Consumer equilibrium is the situation where a consumer gets maximum utility/satisfaction at prevailing prices in the market.
Following is consumer equilibrium using Ordinal Approach or Hicksian Approach which means the consumer can only rank commodities on his/her preference as he cannot express it in numeric terms.
For Ordinal Approach we need to learn about:
- Indifference Curve – It is curve which shows different combinations of two commodities yielding at the same level of satisfaction to the consumer. Each point on the indifference curve indicates one combination of two goods which gives an equal level of utility.
- Budget Line – It is a line showing the different possible combination of 2 goods that a consumer can buy given his budget and prices.
- Marginal Rate of Substitution (MRS) – MRS is the rate at which a consumer is willing to sacrifice/give up fewer and fewer units to one good for an extra unit of other good without affecting his/her total satisfaction.
- Market Rate of Exchange (MRE) – MRE is the rate at which market wants the consumer to sacrifice one good in order to get an extra unit of other good. MRE = (-)Px/Py
Assumptions for Consumer Equilibrium
- The consumer is rational that is he/she aims for maximum satisfaction.
- A consumer consumes only 2 goods X and Y.
- Prices of X and Y are constant.
- The income of the consumer is constant.
When MRS = MRE i.e. the rate at which consumer is willing to sacrifice Y to get an additional unit of X is equal to the rate at which market wants him to sacrifice. In the above diagram, there are 3 ICs – (Indifference Curve) IC1, IC2 & IC3 and a Budget Line which AB.
IC3 is above the budget line which shows that it is not possible for a consumer to achieve that level of satisfaction at this budget. IC2 is tangent to Budget Line and meet only at one point i.e. pt. E which shows MRS = MRE. IC1 also meet budget line at two points C & D but the consumer will move to IC2 (higher IC give higher satisfaction) as a consumer is rational.
There at pt. E Consumer Equilibrium is reached as MRS = MRE
MRS > MRE
In this case, a consumer is willing to sacrifice more of Y to get an additional unit of X than what market wants him to sacrifice.
By consuming more and more units of X the utility derived from X will keep on decreasing; therefore consumer will be willing to sacrifice less of Y to gain additional unit of X. Due to this MRS declines and will keep on declining till MRS = MRE and Consumer Equilibrium is reached.(there will be no change in the MRE as prices of both the goods are fixed/constant).
MRS < MRE
In this case, a consumer is willing to sacrifice less of Y to get an additional unit of X than what market wants him to sacrifice.
By consuming fewer and fewer units of X, the utility derives from X will keep on increasing; therefore consumer will be willing to sacrifice more of Y to gain an additional unit of X. Due to this MRS rises/increases and will keep on increasing till MRS = MRE and Consumer Equilibrium is reached. (There will be no change in the MRE as prices of both the goods are fixed/constant).
For this Law of Diminishing Marginal Utility should work because without LDMU there will no decrease in marginal utility if we consume more unit of a good and no increase in marginal utility if we consume a fewer unit of a good.