Consumer Equilibrium 56 pueeeeesseesssss| Unit-I berrr Essay Questions a 1. Explain the Law of Diminishing Marginal Utility with a suitable diagram and limitations. Ans: Economists carried utility analysis on the basis of cardinal and ordinal numbers. Where as Alfred Marshall developed cardinal utility analysis, Hicks and Allen used ordinal utility approach for analyzing the consumer behavior. According to cardinal approach, utility can be measured i.c., utility or satisfaction can be expressed in terms of numbers. Itis explained with the help of the law of diminishing marginal The Law of Diminishing Marginal Utility:The want satisfying power of commodity is called utility. It is an universal fact that when a person acquires more and more units of the same commodity during a particular time, the utility he derives from the successive units will diminish. In other words, the additional satisfaction derived from the additional units of a commodity goes on decreasing HLH. Gossen was the first economist to explain the law of diminishing marginal utility (1854) and the law of equimarginal utility. W.S. Jevons named them as Gossen’s first & second laws of consumption (1871). In 1890 Marshall in his “Principles of Economics” developed and popularized this analysis. Assumptions of the Law:The law of diminishing marginal utility is based on the following assumptions. 1. TheMarshallian exposition of the law of diminishing marginal utility is based on the cardinal measurement of utility i.e., utility can be measured, compared and added.It B.Com (Semester - Il) Principle of Economics 57 2. Theunits of the commodity are homogeneous. It means, the successive units of the commodity should not differ in any way, either in quality or in size. 3. The law is based on the assumption that is possible to divide the commodity in to small units. 4. There should not be any time gap between the consumption of one unit and the other unit. 5. Theconsumer’s wants, tastes and preferences should remain the same throughout the period of consumption. Explanation of the Law of Diminishing Marginal Utility:Thelaw of diminishing marginal utility explains the relationship between the quantity of a good and its utility or satisfaction. Ifa consumer goes on increasing his stock ofa thing, the additional utility derived from an additional unit declines. The law is clear from the following table. Units of the commodity | Total utility | Marginal utility (Apples) (Utils) (Utils) 01234567 0479101097 043210-1-2 From the table above, we can observe that as the units of the commodity increase, the marginal utility derived from each successive unit tends to diminish. The total utility increases at a diminishing rate till the 5" apple and becomes maximum. Marginal utility becomes zero (0) at that level. For the 6" and 7“ apples total utility declines and marginal utility becomes negative The relation between total utility and marginal utility can be explained thus : 1. When total utility increases at a diminishing rate, marginal utility diminishes, 2. When total utility is maximum, marginal utility becomes zero. 3. When total utility decreases, marginal utility becomes negative. The law of diminishing marginal utility can also be represented diagramatically with the help of the marginal and total utility curves.Consumer Equilibrium 58 12 10 8 yeu 8 stargna\ ny hbowas The horizontal axis shows the units of the commodity and vertical axis measures the utility obtained from the units. The curve TU represents total utility and the MU represents marginal utility curve. The total utility curve slopes upwards to the right indicating that total utility will increase with the consumption of additional units. But the increase in total utility is at a decreasing rate. Total utility is maximumat the 5" unit. From the 6" unitit starts declining. The MU curve has downward slope. The 5" unit of the commodity gives zero marginal utility while 6" and 7" units give negative utility when MU curve intersects the X- axis, the TU curve is at its peak which means when the total utility is maximum marginal utility is zero, when the total utility curve starts moving downwards, indicating that marginal utility is negative. Importance of the Law: 1. Useful to the Finance Minister:The Finance Minister can justify progressive taxation on incomes on the ground that rich people feel relatively less burden in paying a high tax as marginal utility of moncy is lower for them. 2. Basis for the Theory of Value:The law of diminishing marginal utility helps in knowing the difference between Value in use and value in exchange. It explains the paradox of value. 3. Basis for the law of demand/Explains the Negative slope of demand Curve:The law of demand is based on the law of diminishing marginal utility. The law of demand explains that as theIt B.Com (Semester - Il) Principle of Economics 59 price of a commodity falls, its demand goes up. This is due to the diminishing marginal utility of the commodity to the consumer as he purchases more of it. 4. Determination of Optimum Consumption:The law of diminishing marginal utility is useful in determining the optimum level of consumption. Consumption is determined at that level where marginal utility becomes equal to the price. At that particular level, the consumer attains maximum satisfaction from his expenditure. 5. Useful in the Distribution of Wealth:The law is the basis of equitable distribution of wealth advocated by the socialists. It helps in the redistribution of income. Exceptions to the law: According to the law of diminishing marginal utility, as we go on consuming more and more units of a commodity, marginal utility ultimately falls. But thisis not always true. There are exceptions to this law. i) Durable commodities:The law does not apply to durable commodities. As these goods are used over a long period of time, it is not possible to measure utility. ii) Complementary goods:The law of diminishing marginal utility cannot be applied in the case of complementary goods, where more than one commodity is used to satisfy a want. iii) Indivisible goods.\n the case of indivisible goods, the law is not applicable. Ifthe goods cannot be divided in to small units, itis not possible to measure the marginal utility of additional units. 2. Explain the Law of Equi Marginal Utility with a suitable diagram and limitations. (OR) Write the Law of Maximum satisfaction (OR) Explain the concept of consumer Equilibrium with a suitable diagram and limitations. (OR) Explain the Law of Substitution with a suitable illustration. Ans:Law of equi-marginal utility is one of the important laws in consumer behaviour theories. This law explains that how the consumer spends his entire limited income on different commodities to get maximum satisfaction. This is also known as Gossen’s second law and law of maximum satisfaction. This law is being practiced by human beings in real life. Alfred Marshall developed this theory.Consumer Equilibrium 60 Definition: Ifa person has a thing which can be put to several uses, he will distribute it among the uses in such a way that it has the same marginal utility in all” Alfred Marshall. The above definition states that, in order to get maximum satisfaction, a consumes spends his limited income upon different goods in the manner that the marginal utilities of all goods are equal. That’s why this theory is known Equi-Marginal utility theory. Assumption:This theory depends on some assumptions which are given below 1. The consumer has limited income and he is ready to spend entire income 2. Utility obtained from consumption can be measured 3. Consumer knows the prices and utilities goods 4. Marginal utility of money is constant 5. Consumer’s behaviour is rational and tries to get maximum satisfaction 6. Tastes and preference of the consumer are fixed. With the following example the theory can be understood well. Suppose a person has Rs.6. He wants to spend his limited income Rs.6 on different goods namely x and y. As per law in the beginning he purchase the units which give more marginal utility. He spends his last rupees on the units of goods which give same level of marginal utility. The following table explain how he spends income on goods x and y and how he maximizes his satisfaction. Money (Rs) Marginal Utilityof | Marginal utilityof goods x (utils) goods y (utils) 6) 9 Total UtilityIt B.Com (Semester - Il) Principle of Economics 61 Figures in the brackets show as to how the consumer spends his six rupees on two types of commodities. Let us assume that the price of cach commodity is one rupec. The consumer starts spending his first rupee on X because the highest marginal utility on X is 19 utils. In the same way he spends his 2"!, 3", 4"& 5" rupee on the same commodity as it gives the next highest utilities, that is, 17, 15, 13 & 11 respectively. Then the 6" is a spent on commodity Y. In this way, the consumer spends rupee after rupee till he spends all the six rupees with him. Thus, the total utility obtained from X will be 19+17+15+13+11 = 75 and the total utility obtained from Y will be 11. Therefore the total utility that the consumer gets by spending Rs. 6 (5+1) completed will be 75+ 11 = 86 utils. In this way the consumer spends his entire income on X and Y in such away that the last rupee spent on X and last rupee spent on Y gives the same marginal utility. The total utility from both rupees. Any other allocation of six rupees given him less than 86 utils of total satisfaction to the consumer. Thus the consumer gets maximum satisfaction by spending Rs.5/- on X and Re.1/- on Y. M=PQ,+PQ, 6=1x54I1xl MU MU, MU, _,, PP, M= Money income; P. =Price of X good; P, = Price of Y good, QO, = Quantity of X good ; Q, = Quantity of y good If the consumer spends his entire income of Rs.6/- on commodity X i.e., the total utility obtained will be only 84 utils. On the other hand, ifhe spends his entire income on commodity Y the total utility will be only 36 utils. Therefore, the consumer spends hisConsumer Equilibrium 62 income on both the commodities. Hence, 5 units X and 1 unit of Y is the best combination which the consumer can purchase with his limited. income of Rs.6/-. The last rupees spent on X and also the last rupee spenton Y will givethe same satisfactioni.c., 11 utils. There is another point where the marginal utility (9) is same for both the commodities. But with the limited moncy of Rs.6/- the consumer can not buy that combination. We can illustrate this principle with the help ofa diagram also. Money expenditure is shown on X axis and the marginal utility derived from the commodities X & Y is shown on Y axis. Marginal utility of commodity X is shown by he curve XX and marginal utility ofcommodity Y is shown by the curve YY. D,\7, marginal utility of X is equal to DM the marginal utility of Y, D,A¢, = DM indicates that the marginal utilities ofboth the commodities are equal (11 utils). The amount spent on commodity Xis OM, (Rs.5) and the amount spent on commodity Y is OM (Re. 1). The consumer isin equilibrium by purchasing the combination of 5 units of X commodity and 1 unit of Y commodity as he obtains the maximum total utility at that purchase. Marginal Utility of Money M M, Money ExpenditureIt B.Com (Semester - Il) Principle of Economics 63 Limitations : The law of equi-marginal utility has some limitations : 1. The law cannot be applied to indivisible goods. 2. Utility is a psychological feeling and therefore it is not possible to calculate and compare the marginal utilities and to equate them. 3. The law assumes that the marginal utility of money remains constant. But in reality this is not true. 4. The law assumes that the consumer is rational. But in reality, he does not behave rationally all the time. Many consumers do not bother about the maximization of utility. In such cases the law does not work. 5. Ignorance on the part of the consumer about market prices, utilities of different goods etc., becomes a limitations to the operation of the law. Importance of the Law of Equi Marginal Utility: Despite alll the above limitations, the law of equi marginal utility is of great practical importance. As resources are limited, people try to make the best use of them. This can be done by the application of the law in various aspects of life. The practical importance of the law can be explained as follows. i. Consumption: The law of equi marginal explains as to howa consumer maximizes his satisfaction from his limited resources. 2. Production:In order to get maximum output, the producer substitutes one factor whose marginal productivity is higher fora factor whose marginal productivity is lower. This substitution continues till the marginal productivities of all the factors become equal. 3. Exchange: Exchange is based on the law of substitution. Exchange is nothing but substitution of one commodity for another. When we sell a commodity, we get money. This money is used to buy another commodity.Consumer Equilibrium 64 4. Distribution: The law of equi marginal utility applies to distribution also. Law of substitution is helpful in equalizing the marginal productivitics of different factors of production. The law ofequi marginal utility has thus a very wide application. 3. Critically examine the concept of Consumer Surplus. Ans:The concept of consumer’s surplus was introduced into economic analysis by Prof. Marshall. If the price was actually pay for acommodity is less than what we are willing to pay for it, we get an excess or surplus satisfaction. This surplus satisfaction is called “consumer’s surplus’. The consumer does not actually pay the maximum amount of money that he is willing, to pay for the purchase of commodity. For example, in a place where salt is very scarce we would have paid one rupee for a spoon of salt, rather than go without it. It shows the price we are willing to pay. But suppose the actual price in the market is only two paise per spoon of salt. We are getting a surplus satisfaction of 80 paise because the price we were willing to pay was one rupee while the actual price we pay is two paise. Such consumers surplus is to be found especially in the case of commodities which are highly useful but which are cheap, for example, post card, newspaper, matches, salt etc. Assumption of consumer’s surplus: The concept of consumer’s surplus is based on the following assumptions. 1. Expected and realized utility are same. 2. Tastes and preferences of the consumer remain same. 3. Marginal utility of money remains same. 4. Utility of a commodity depends on the quantity of that commodity only. Each commodity is treated as an independent commodity. 5. While considering market consumer’s surplus, the differences between consumers are ignored. Consumer surplus — diagrammatic explanation: Based on the above assumptions we can explain consumer surplus with the following diagram.I B.Com (Semester - Il} Principle of Economics 65 Consumer < Surplus xX Oo Units at Commodity In the above diagram OPis the product price. At that price he buys OM quantity. Therefore, the total moncy he pays is OP "OM= OMSP. But according to the demand curve he is willing to pay OMSD. Therefore, consumer’s surplus OMSD —- OMSP = PSD. Shown by the shaded area. Criticism:The concept of consumer’s surplus is criticised by several economists. The following are some points of criticism. 1. Potential prices are not known: It is not possible to know the prices that consumers would be willing to pay. Acomplete list of demand pries is not available. What we would have paid is something imaginary. 2. Difference in consumers circumstances:Rich man would be willing to pay much more for a commodity than a poor man. Therefore, consumer’s surplus differs from person to persons. 3. Differences in sensibilities: Tastes and sensibilities differ from person to person. Therefore, some persons may be willing to pay much more than other. 4. Market consumer’s surplus difficult to measure: As the circumstances, sensibilities etc, differ from person to person, market consumer’s surplus cannot be measured. 5. Marginal utility of money not constant: As we go on buying a commodity, we have less and less money with us. Therefore, the marginal utility of money increases. It docs not remain constant.Consumer Equilibrium 66 6. Utility of earlier units changes: As we purchase more units of a commodity, the utility ofthe earlier units purchased will also diminish. The utility schedule will not be as before. It has to be changed every time when we make a purchase. 7. Presence of substitutes: Many commodities have substitutes. Tea and coffee are substitutes. When there are substitutes, there is no question of ‘what the consumer is willing to pay rather than go without it’. He can use a substitute ifthe commodity is not available. 8. Goods having prestige value: Goods like diamonds have prestige value because their prices are high. Ifthey become cheap rich people may not buy them because they have lost the prestige value. When the satisfaction is less at a lower price, there is no consumer’s surplus. 9. Assumption of independent utilities wrong: The utility of a commodity depends on the supply of other commoditics also. 10. Based on subjective utility:Cannot be measured: Utility isa mental feeling. It cannot be measured. Consumer surplus through Indifference curves: Hicks’ considered the surplus as a monctary gain to the consumer which results due to the opportunity open to the consumer to participate in the market and benefit from its functioning. This can be explained with the help of the following diagram. YA M Money Income Q P of S AWN Consumer ICy IC) 5 ~ N im Commodity,It B.Com (Semester - Il) Principle of Economics 67 By the diagram commodity X is shown on X axis. Money income of consumer is shown on Y axis. We suppose that the consumer has OM amount of money income further, we suppose that the consumer does not know the price of the commodity at present. So, the consumer has to express his preference for the commodity X in terms of the income he is prepared to forego for obtaining a desired amount of the commodity. Let us suppose in this situation, the consumer chooses the point R on IC,. In the chosen combination R, on his indifference map the consumer is having ON units of commodity X and OS amount of money income. In other words, in this situation, the consumer is ready to sacrifice MS amount for getting ON units of commodity X. Now we suppose that the consumer is informed of the market price of commodity X, which helps him in knowing his price line. Let ML be the price line. The slope of the price line shows the price of commodity A. By the diagram P is a point where price line is tangent to the higher indifference curve IC,. The point of tangency P is called equilibrium point. So, the consumer buys ON units of commodity A for which he has to pay only MA amount of money, an amount higher than the actual amount of money henow pays. ThereforeMS—MQ =QS is the money measure of consumer’s surplus. Practical importance: The concept of consumer’s surplus has some practical uses also. i. To compare economic welfare or conjunctional advantages: The concept of consumer’s surplus helps us to compare the economic condition of people living at different places. We can compare the standard of living in different parts of the world. Economic welfare is greater in countries where consumer’s surplus is greater. Consumer’s surplus will be high in places where prices are low. 2.Shows the advantages derived from falling prices:When the price of a commodity falls the consumer’s surplus will increase. The sum total of satisfaction increases. Therefore, itis auseful tool in the analysis of Economics of welfare.Consumer Equilibrium 68 3. Determination of Monopoly price: The concept is useful for a monopolist in fixing his price. He can fix a higher price for a commodity having large consumer’s surplus because the consumer would be willing to pay higher prices. An idea of the consumer’s surplus is useful for a monopolist to determine the price he should charge. 4. In International trade: The gain from international trade can be measured with the help of this concept. Generally, a country imports goods because they are cheaper. If we produce in our country they cost more. Therefore, the difference between the price ofimports and the price we would have to pay if produced within the country is the consumer’s surplus or gain from international trade. 5. In Public Finance: In taxation, the Finance Minister should carefully select commodities on which the consumers enjoy large consumer’s surplus. 6. Consumer’s surplus and elasticity of demand: If the consumer’s surplus on a commodity is very high, the demand for that commodity will be inelastic because people do not mind paying ahigher price. For example, consumer’s surplus is high for necessaries and so the demand for them is inelastic. Ans:Hicks and Allen used ordinal utility approach for analyzing the consumer behaviour. According to the ordinal approach, utility is subjective. It can not be measured cither practically or theoretically. Indifference curve analysis is based on ordinal measurement of utility. Indifference Curves:The indifference curve analysis measures utility ordinarily. It explains consumer behaviour in terms of his preferences or rankings for different combinations of two goods, say X and Y. An indifferent curve is drawn from the indifference schedule of the consumer. Indifference Schedule Combination xX Y 123456 123456 18139643It B.Com (Semester - Il) Principle of Economics 69 In the table above, the consumer is indifferent weather he buys the first combination of units of 18 y + 1 unit X or the fifth combination of 4 units of Y + 5 units of X or any other combination. All combinations give him equal satisfaction. Ifthe various combinations are plotted on a diagram and are joined by a line this becomes an indifference curve, It shows below. Goods X In the diagram above the indifference curve IC is the locus of the points L,M,N,P.Q, and R, showing the combinations of the two goods X and Y between which the consumer is indifferent. “It is the locus of points representing pairs of quantities between which the individual is indifferent, so it is termed an indifference curve”. It is, in fact, an iso-utility curve showing equal satisfaction at all its points. Assumptions of Indifference Curve Analysis:Indifference curve are based on the following assumptions. 1. Aconsumer is interested in buying two goods in combinations 2. Heisableto rank his preferences and give a complete ordering of the scale of preferences. 3. Theconsumer always prefers more quantities of goods to a lesser quantities. 4. Heis rational and his choices are transitive. That is to say, he is always consistent in his choice. That means, when he prefers combination A in the indifference map to combination B, and BtoC, then he must also prefer A to CConsumer Equilibrium 70 5. There is ordinal measurement of utility, so the height of the indifference curve indicates the level of satisfaction with out quantification. 6. Indifference curves are drawn as continuous curves by assuming infinite amount of changes in the combination oftwo goods. This implies perfect divisibility of the goods under consideration. Properties of Indifference Curves:Indifference curves have certain properties reflecting assumptions about consumer behaviour. They are as follows. 1. Indifference curves are negatively-sloped:Indifference Curves slope downwards from left to right, i.¢., negatively -sloped, indicating that as the quantity of X increases in the set of combination of X and Y, there should be a decrease in the amount of Y, if the consumer remain at the same level of satisfaction as units of one commodity are added we must give up some amount of other commodities, we can explain this with the help of diagram and other impossible slopes. Y Commodity ox & x x % ox x% X commodity In the diagram ‘A’ the Indifference curve falls down from left to right B and C are the impossible diagrams. In the diagram “B’ at point A consumer uses OX, of X commodity and OY, of Y Commodity, he gets some satisfaction. At point “B’ the quantity of X commodity has been increased to OX, and that of Y to OY,, Therefore, at point B consumer gets more satisfaction than that of A because of increase of both the quantities. In the diagram C at point B the quantity of X commodity has been increases and there in no change or no reduction in the quantity of Y commodity. Therefore, the point B gives more satisfaction than that of point A.It B.Com (Semester - Il) Principle of Economics 71 2. Indifference curves are convex to the origin:The Indifference curve is always convex to the origin. This property of indifference curve is based on the assumption of the diminishing Marginal rate of substitution. The indifference curve is convex to the origin because the consumer is prepared to sacrifice, lesser and lesser quantity of Y commodity in order to get the additional units of x commodities. Ifthe indifference curve is concave to the origin, the marginal rate of substitution will be increased. Therefore, indifference curve should not be like that. This things can be shown with the help of following diagrams. y y (A) Y, Y, pY, ¥, g ° 5 ¥, XY, oy ~Y, 1c ox % xX, ox x «x, * X Commodity In the diagram ‘A’ indifference curve is convex to the origin. Because of increase of X commodity from X, to X,, the consumer giveup Y , to Y, quantity of Y commodity. In the diagram the quantity of Y commodity that give up is gradually diminishing because of getting of additional commodities of X. In the diagram “B’ the quantity of Y commodity that given up is gradually increasing because of increase of additional commodities of X, In this the marginal rate of substitution is increasing. This is contrary to our principle and therefore, the indifference curve is not concave to the origin. 3. Indifference curves should not intersect each other:Indifference curve should not intersect each other. Each indifference curve represents a particular value of satisfaction. The following diagram explains the impossible nature of indifference map.Consumer Equilibrium 72 “ Y¥ commodity oO X commodity In the diagram above the point ‘C’ on IC, indifference curve given more satisfaction than that of the point “B’ on IC, indifference curve to the consumer. But these two indifference curves intersect each other at point A, but this is not possible. 4. Higher indifference curve represents higher level of satisfaction: The indifference curve that lies above or shift to right side represents higher level of satisfaction. This can be explained with the help of following diagram. Y, x, A B 2 3 IC, z $ IC, > 0 x x x X Commodity In the diagram the IC, indifference curve lies above to the indifference curve IC, Since IC, is the higher indifference curve, it gives more satisfaction to the consumer. At point *A’ on IC, curve consists of OY , quantity of Y commodity and OX, quantity of X commodity and this combination give some satisfaction to the consumer. At point “B’ on IC, the consumer uses more of X commodity without any reduction of Y commodity. Therefore, this combination “B’ gives more satisfaction than that of combination ‘A’ to the consumer.It B.Com (Semester - Il) Principle of Economics 73 5. Indifference curve will not touch either X - axis and Y-— axis:The indifference curve will not touch either X — axis or Y— axis, as we have assumed that the individual is interested in different combination of two commodities. The impossible slope of indifference curve is shown below. Y w Y commodity x o X commodity A In the diagram the indifference curve touches X — axis at point A’ and the Y-axis at point B, therefore at point A, he will be satisfied with OA units of X commodity and no preference for Y commodity. Similarly, at point B, he will have OB units of Y commodity and none of X, This normally does not happens. Therefore, indifference curve will not touch either X-axis or Y-axis. 5. Write the consumer Equilibrium with the help of Indifference Curve analysis. Ans: Rational Consumer attains an equilibrium position when his motive of maximizing satisfaction is realized. Marshal has given the “Proportionately rule’ : MU, _M U Po Py consumer’s equilibrium. But based on the cardinal measurement of utility, his approach was very much criticized. Hence, Hicks came forward with an alternative approach in terms of the ‘ordinal —— etc., in his marginal utility analysis of theConsumer Equilibrium 74 preference’ or indifference curves. Under the approach, the assumption that the consumer tries to maximize satisfaction is retained, but maximizing satisfaction no longer means achieving the maximum. total utility but rather reaching the higher level of satisfaction’. In the indifference curve approach, the equilibrium position of aconsumer is traced under following assumption. The consumer has a fixed amount of money income to spend. 1. He intends to buy a combination of two goods X and Y. 2. The prices X and Y are given and are constant. Thus, the ratio PxiP, is fixed. So the budget line or the price line has a constant slope. 3. Each of the goods X and Y is homogencous (i.c., all its units have identical characteristics) and divisible, so that various combinations of there goods can be had. 4. The consumer has definite tastes and preferences. So, he has a given scale of preference expressed through an indifference map. This scale of preference remains the same throughout the analysis. IC O_ y-commodity _. x-commodity X 5. Theconsumer is rational. The rationality assumption implies that the consumer seeks maximization of his satisfaction. Thus, in terms of indifference curve, the consumer acts to reach the higher possible point on the indifference curve, i.e., the highest level of satisfaction. In order to find out the equilibrium purchases of the consumer, we should consider the scale of preference, i.c., indifference map and the budgct line simultancously.It B.Com (Semester - Il) Principle of Economics 75 Y > y-commodity © Xx x-commodity Indifference Curve: The indifference map represents the subjective scale of preference of the consumer based on his taste, habit and liking. It is shown in the below diagram. Price Line: The price line or the budget line represents the budgetary constraint relating to the opportunities of combining two goods, based on the objective consideration of market prices of these goods and the consumer’s income. It is shown in the below diagram. Hence, it should be noted that the indifference map and the price line are quite independent of one another. That is to say, the consumer has a scale of preference which does not depend on prices or income. But, it is also a fact that the consumer cannot purchase beyond the budget line. Conditions of Equilibrium: 1. Indifference curve must become tangent to the budget line. 2. Equilibrium point is convex to the origin. Pp P. ¥ The maximum satisfaction is yielded when the consumer reaches equilibrium at the point of tangency between an indifference curve and the price line. It shows the diagram below. In the diagram above, there can be one such indifference curve (IC,) tangent to the price line. And this indifference curve is of the highest order on the consumer’s scale of preference within his reach. 3, MRS, =Consumer Equilibrium 76 y Y-Commodit Zz X-Commodity It follows, thus, that the consumer cannot be in equilibrium at the point of intersection between any indifference curve and the price line. Like C and D points on the IC, curve. In the diagram, it may be observed that, in a technical sense, at this most preferred position - point E, the equilibrium point, here the price line is tangent to the indifference curve IC,. We may, thus, conclude: A Slope of indifference curve = x = MRSxy P P. Slope of price line = a ¥ At equilibrium point, Slope of indifference curve = Slope of Price line P. MRS,, =— B Thus, in an economic sense, it may be restated that:Satisfaction is maximized when the marginal rate of substitution of x for y is just equal to the price of x to price of y.It B.Com (Semester - Il) Principle of Economics U7 6. Explain the Consumer Surplus with the help of in difference curves, Ans :Consumer surplus through Indifference curves: Hicks’ considered the surplus as a monetary gain to the consumer which results due to the opportunity open to the consumer to participate in the market and benefit from its functioning. This can be explained. with the help of the following diagram. ya M Money Income Q P of g AWN Consumer IC, IC, oO N LO Xx Cc ommodityy. By the diagram commodity X is shown on X axis. Money income of consumer is shown on Y axis. We suppose that the consumer has OM amount of money income further, we suppose that the consumer does not know the price of the commodity at present. So, the consumer has to express his preference for the commodity X in terms of the income he is prepared to forego for obtaining a desired amount of the commodity. Let us suppose in this situation, the consumer chooses the point R on IC,. In the chosen combination R, on his indifference map the consumer is having ON units of commodity X and OS amount of money income. In other words, in this situation, the consumer is ready to sacrifice MS amount for getting ON units of commodity X. Now we suppose that the consumer is informed of the market price of commodity X, which helps him in knowing his price line. Let ML be the price line. The slope of the price line shows the price of commodity A.Consumer Equilibrium 78 By the diagram P is a point where price line is tangent to the higher indifference curve IC,. The point of tangency P is called equilibrium point. So, the consumer buys ON units of commodity A for which he has to pay only MA amount of money, an amount higher than the actual amount of money he now pays. Therefore MS - MQ =QS is the money measure of consumer’s surplus. 7. Write the Derivation of Demand Curve through IC’s. Ans: Price Consumption Curve explain the relation between price of a commodity and indifference curve. Here the income of the consumer is assumed to be constant. It is possible to derive demand curve of a consumer with the help of IC and Budget Line. Derivation of the demand curve: If we taken one good on’ X axis and another good on Y axis, only combinations of two goodscan be accommodated in our illustration. But actually several goods are consumed by the people. Weshouldbring in more goods into the picture to come nearer to reality. The easiest method to do this is to take money on Y axis and a good on the X axis. Since money is general purchasing power, it represents any number of goods. Bh» a | 81 \S | IN ic AL P, Lo + P, ! i ° TT, F, QUANTITY OF XIt B.Com (Semester - Il) Principle of Economics 79 Inthe figure, the top segment shows the consumers equilibrium and the price consumption curve. The segment below shows the demand curve. QuantityofXisshownonthe X axis and income on the Y axis. The first budget line is BC. T shows the consumer’s equilibrium then. The line drawn from T is extended down to the X axis on the segment below. OT is shown to be the quantity demanded. In the segment below; price is shown on the Y axis. OT is shown to be bought at OP price. Now, how do we know the price to be OP? We know from the BC budget line that OC can be purchased with OB income. If we divide OB income by OC output (OB/BC) we come to know the price OP. We have thus derived one point needed for the demand curve. Next, the price falls. OC, can now be bought with the same OBincome. The new budget line is BC, . This is tangential to IC, at T,. T, shows the equilibrium. The straight line drawn from T, to the X axis gives us the quantity OT,. If OB is divided by OC, (OB/ OC,) we get OP, price. At OP price, OT, quantity is bought. This is second point on the demand curve. Suppose the price falls once again Now OC,can be bought with the same income OB. BC, is tangent toIC, at T,. This point T, shows the equilibrium of the consumer. The perpendicular drawn from T, gives the quantity bought OT.,,. If OB is divided by OC, (OB/OC,), we get the price OP,. At OP,, the consumer buys OT, quantity. This is the third point on the demand curve. Ifthe equilibrium points T, T, , T,are joined together by a line, we get the PCC or the price consumption curve. We derive the quantities bought from the PCC and the prices from the budget line Demand curve is then drawn on the basis of this information. Demand. schedule is given below. 8 Write about Price Consumption Curve or Price Effect. Ans: Price Consumption Curve explain the relation between price of a commodity and indifference curve. Here the income of the consumer is assumed to be constant.Consumer Equilibrium 80 Price Consumption Curve or Price Effect: \n the figure given below, BC is the budget line. It is tangential to the indifference curve IC, . Tis the Point of equilibrium. OC of X can be bought with the money available But OM of X will be bought. This can be obtained. by drawing astraightline from T to the X axis. Now let us suppose that the price of X has fallen down. (There is no change in the price of Y.) OC, of the X can be bought with the present price in forece. New budget line is BC,. This starts from B on the Y axis, but ends a C, (not C) on the X axis. This budget line (BC,) is tangential to the indifference curve IC,. The new equilibrium is at thepoint T,. The quantity of X bought increases from OM to OM. If the price falls again, BC, budget line will be formed. It will be tangent toIC,. The new equilibrium will be T,,. If we draw a line joiningall the equilibrium points T, T, and T,we get the price consumption curve (PCC). Price-consumption curve reveals to us the price effect. Price effect tells us the change in the quantity consumed as a result ofa change in the price. Quantity of Y OM M, Mp Cy Cc Cy Quantity of X Price Consumption Curve: demand curve: Price consumption curve is not the demand curve. The following are the points of difference between the two.It B.Com (Semester - Il) Principle of Economics 81 1. PCC has the quantities of two commodities on the two axes Demand curve has price on one axis and quantity on another axis. 2. PCC does not show the price directly. But demand curve must have the price as well as the quantity shown. 3. PCC along with the income consumption curve can separate the income effect and the substitution effect. But the demand curve can show only the price effect. Demand expands when the price falls. This is the price effect. There are two reasons for such expansion of demand. First when the price falls, the same quantity can be bought with a smaller amount of money. So some money remains unspent (i.e.) real income increases. More will be bought asa result ofincrease in the income. This is called income effect. Second: Price of the good has fallen while other prices remain the same Le., its relative price has gonedown. Therefore more will bebought of the commodity. This is called substitution effect. More of this good is bought instead of others. Both these factors are responsible for greater purchases when the price falls. Therefore, Price effect = Income effect + substitution effect Indifference curve analysis has demonstrated that price effect can thus be divided into these two effects. The neo-classical utility analysis has not done that. Income effect reflects the new utility gained by the consumer asa result of the fall in price. For the real income increases. It enables the consumer to get larger amount ofgoods in all. Substitution effect does not have this kind of change. Just more of this particular good is purchased instead of the other goods as a result of a fall in its price. Therefore it is necessary to separate the two effects and identify them as such.Consumer Equilibrium 82 Short Answer Questions 9. Define utility. Explain the types of Utility. Ans: Utility: The want satisfying capacity contained in a good is said to be its utility. In economics the term utility is used to denote satisfaction or welfare. Utility is ethically neutral. The utility from all units ofa good is called total utility. Utilities are derived from good are of different form such as: i. Form Utility: A good has the capacity to satisfy a want only when it is ina particular form. The good, then is said to have form utility. For example, when a chair is made out of wood, the chair gets the form or shape utility. 2. Place Utility: Some goods acquire utility because of place. For example, the goods produced in the industries gain place utility when they reach market yards. 3. Time Utility: Some goods acquire utility because of time. For example, business people stock the goods and create time utility. Food grains are bought during the harvest season and stocked. Time utility is gained by selling them at a later date. 4. Service Utility: Services also have the capacity to satisfy the wants. The utility from these services is called services utility. For example, services of teachers and doctors. 10. Distinguish between cardinal utility and ordinal utility. Ans: The want satisfying capacity of anything is known as Utility. Utility is the basis of consumers demand for a commodity. There are two different approaches of utility to analyze the consumers behavior. A) Cardinal utility, B) Ordinal utility. Cardinal Utility 1. Alfred Marshal followed cardinal utility approach to explained he theory of consumers behavior. 2. Wecan measure utilities derived from the consumption of different commodities in terms of orbitary constants called “utils?It B.Com (Semester - Il) Principle of Economics 83 3. 1,2,3,4 are called cardinal numbers. 4. According to cardinal utility approach, it is possible to measure and compare utilities derived from different commodities. 5. Thelaw ofdiminishing marginal utility and law of equi marginal utility are based on cardinal utility approach. Ordinary Utility 1. Hicks, Allen gives support to this ordinary utility approach. 2. According to this approach we can not express utility in numbers precisely. It can be ranked. 3. Itcan be arranged in serial order such as 1, 2™, 3 etc. 4. Ordinal utility approach says that utility can not be measured. in numerical terms. It isa subjective concept. 5. The indifference curve analysis is based on ordinal utility approach. Il. Define Indifference curve. Explain its assumptions. Ans-Hicks and Allen used ordinal utility approach for analyzing the consumer behaviour. According to the ordinal approach, utility is subjective. It can not be measured either practically or theoretically. Indifference curve analysis is based on ordinal measurement of utility. Indifference Curves:The indifference curve analysis measures utility ordinarily. It explains consumer behaviour in terms of his preferences or rankings for different combinations of two goods, say X and Y. An indifferent curve is drawn from the indifference schedule of the consumer. Indifference Schedule Combination x Y 123456 123456 18139643 In the table above, the consumer is indifferent weather he buys the first combination of units of 18 y + 1 unit X or the fifth combination of 4 units of Y + 5 units of X or any other combination. All combinations give him equal satisfaction. Ifthe various combinations are plotted on a diagram and are joined by a line this becomes an indifference curve, It shows below.