UTILITY

&
CONSUMER
EQUILIBRIUM
Ut ility : Us e satis faction deriv ed f rom
consum pt ion.

Tot al ut ili ty: Tot al psy cholo gic al sat isfaction

ob tained by a cons umer from consum ing
given am ount of a part icular com modity is
call ed t otal utility.

Inc rea se in to tal ut ilit y bu t de crea se in

margi nal (ad ditional) utili ty. By consum ing
succ essi ve unit s of a part ic ular com modity,
the tot al util it y go es on increasing, rem ains
constan t at zero level and goes on
Margi nal Utility :
The ut ili ty deriv ed from the consum pt ion of
last unit is term ed as margi nal utility. It is the
ut ility deriv ed from the consum pt ion of the
ad ditional u nit.

The tot al utility is the sum tot al of marginal

ut ilitie s.

La w of dim inishing m arginal u til it ies :

The pat tern of de clining the margin al utili ty
with the cons umption of suc cess ive uni ts is
call ed t he la w of dim inishing m arginal u til it y.
Units (T) Total Utility Marginal Utility

1 20 20

2 38 18

3 53 15

4 64 11

5 70 6

6 70 0

7 62 -8

8 46 -16
Tot al ut il ity is maxim um (7 0) when margina l
ut ility is zero i.e. at the 6 th un it.

Mars ha ll sta tes t he law :

The add itional be nefit whic h a person derives
from a given inc re as e of his stock of a thing
dim inishes with every increase in stock that
he already h as .
22

20 Q

18 R

16
S
14

12
T
10

6 W

-2

-4

-6

-8

-10

-12

-14

-16 MU
-18
Lim ita tions o f law :
1. Suitable units
2. Suitable tim e
3. No change in consum ers t aste
4. Con stant incom e
5. Rare c ollectio ns
6. Cha nge in oth er p eoples stock
7. Othe r poss essions
8. Fashion
9. Not app licable to money
10. Norm al person
Ma rginal u ti lit y o f m oney:
Does th e la w of dimi nish ing MU apply to
mo ney?

Ma rginal u ti lit y a nd price :

Ma rginal u ti lit y i ndica te p rice.
Pr ice and ma rginal util ity mo ves togeth er up
and d own

Ma rginal u ti lit y a nd su pply:

MU i s a f uncti on of s upp ly
Mo re th e su pply, th e l ess wil l b e MU
MU va ri es i nversely w ith su pply
Margi nal Utility (M U) and Sub stitut es :
Tea & Co ffe e, Rail and Road, A ir Transport

MU of Tea de creases as the quan tity of

coff ee increases with th e custom er.

Com plem ent ary good s:

Paper, Pen and ink. Stock of on e increases
the M U of ot hers.

MU or rare go ods (Gif fens Parad ox )

increases as its stock go down.
Prac tical im portan ce:
Taxation
Pri ce d eterm ination
Hou se hold p urc has e
Down ward sloping dem an d curve
Value in us e – value in e xchang e
Soc ialis m
Bas is of som e Econom ic L aw:
La w of Dem an d
Con sum er Su rplus
Elasticity of dem and
La w of subs titut ion
Indiffe rence Cu rv es :
•Cons umers pref er ma ny things .
•His re sourc es are li mit ed
•He pic k and choos e more urgent desires for
sati sf ac tion.
•His choi ce is bas ed on his relat iv e ev aluati on of
th e ut ili ti es of t he commodi ti es
•He has a def ini te sc al e of pre ferenc e in hi s
purc hase plan
•Ut ili ty is subjec tiv e and henc e ev aluat ion is by
th e cons umer
•Cons umer preferenc e of vari ous comb inati on of
goods depends on eac h one.
•On the bas is of cons umers scale of preferenc e,
we c an draw the i ndif ferenc e c urv e.

•An indi ff erence cu rve represent s sati sf ac ti on of

a cons umer from two comm odit ies . On all point s
of the curv e, the total sati sf ac ti on or ut il it y
remain the sam e. Sinc e the cons um er gets the
same sat is fac ti on fro m any point on the curv e,
th e curv e i s call ed i ndiff erenc e c urv e.
 Combination Oranges Mangoes MRS
1 15 1
16 15A + 1 M 2 11 2 4:1

15 A 3 8 3 3:1

14 4 6 4 2:1
5 5 5 1:1
13
12 11A + 2 M
11 B
10
Oranges 9 8A + 3 M
8 C
7 6A + 4 M
6 D
5 E 5A + 5M
4
3
2
1
0
1 2 3 4 5 6 7
Mangoes
 Oranges

IC5
IC4
IC3
IC2
IC1

Mangoes

In differenc e curv es showing gr eater and les ser

sati sf ac tion. IC1 is the leas t sa ti sf ac tion, where
as IC5 gi ve s the hig hest amount of sati sf ac ti on.
A se t of indif fere nce curv e is call ed an
Margi nal Rat e o f S ubstitut ion :
MRS shows how much of one com mod ity is
substitut ed for how muc h of an othe r or at
wha t rat e a consum er is will ing to subs titute
on e com modi ty for anoth er in his
consum pt ion pa tte rn.

The law of dim inishing marg inal ra te of

substitut ion.
More and more of a goo d X is substitu ted for
a good Y, the marginal rate of sub stitution
dim inishes.
At 1 st sta ge, he was prepared to giv e up 4A
Pri ce L ine or Bu dget Line :
Rat ional consum er tri es to maxim iz e his
satisfaction from his available re sou rc es
He wi ll try to reach the highest possi ble
indiff erence curv e.
In th is h e is governe d by t wo con stra ints:
1. The mone y h e ha s
2. The pric e of goo ds
Suppose consum er has Rs.15 /- an d mang oes
in the mark et is Rs.1 .50 and app le is Rs.1
pe r unit. He can buy 10 mang oes and 0
ap ples or 15 app les and 0 m angoes.
 16
15
14
13
12
11
10
Oranges 9
8
7
6
5
4
3
2
1
0
1 2 3 4 5 6 7 8 9 10 11
Mangoes

By joi ning A and M, we get what is called pr ice

li ne, or pric e oppor tunit y line. Pri ce – inc ome
li ne, Budget li ne, Budget cons train line.
Con sum er Eq uil ibr ium:
A consum er is said to be in equil ibr ium, when
he obtains the maxim um pos sible satisfaction
from his pu rc ha ses given the prices in the
mark et and th e a mount of m on ey he has.

The cons umer will maxim iz e his satisfaction

an d be in equili brium at a po int wher e the
price line touches (or is tan gent to) an
indiff erence curv e.
 16
15
14
13 S
12
11 N
10
Oranges 9
8
7
6 H P
5 IC4
4
3 K IC3
2 IC2
1 L
0 R IC1
1 2 3 4 5 6 7 8 9 10 11
Mangoes
P is the equ ilibrium poin t. At point “P” the
margi nal rate of sub stitutio n (M RS ) of
mangoes fo r apples is eq ual to the pric e ratio
be tween the se two goods. The in di ffere nc e
curve IC3 and the pric e line AM has the sam e
slope a t p oint P.

i.e. MRS for mang oes for apples = Price of

Mangoes
Pri ce o f a pples
Inc ome E ffe ct:

Inc ome ef fect is the eff ec t on the quan tity

de mande d excl usively as a resul t of change
in mon ey incom e. As a result of change in
incom e sat is fac tion will eit her increase or
de crea se. He wil l have a new budge t line
an d hence the equilibri um po int P will shift to
a dif fere nt indif ferent curv e eith er to right
(highe r sat isf ac tion) or to the lef t (lower
satisfaction) .
 13 ICC
12
11
10
9
8
Oranges 7
6 IC4
5
4 C3
3
2 C2
1
C1
2 4 6 8 10
Mangoes
The incom e con sum ption curve shows ho w
the consum pt ion of two good s is aff ec ted by
chang e in inc ome when pric es of bot h go ods
are giv en an d consta nt.

An incom e consum pt ion curv e thu s traces out

the incom e ef fect as th e con sum ers incom e
chang es , cetirus pa ri bas . For norm al goods,
the shape of the curve is slop ing upwa rds to
the ri ght. This means as a rule, a ris e in
consum ers incom e wi ll make him buy mor e of
ea ch of any two go ods he is consum ing .
Inferior good s:
Those goods of wh ic h th e qu antit y th at the
consum er would buy les s, as his incom e
ris es, are call ed infe rior goo ds

For exam ple a poo r villager as his incom e

ris es wi ll buy less of coa rs er grains lik e
millet and buy m ore whea t a nd ri ce.
Su bs titut ion ef fect :

Su bs titut ion eff ect mean s the change in th e

qua ntity of a good purchased wh ich is due
only to th e change in relat iv e pric es, money
incom e rem aining con sta nt. Whe n the pric e of
the good X fa ll s, the real incom e of the
consum er would increase. Even aft er
com pen sat ing this variat ion in incom e, the
consum er wo uld still buy more of X, because
X has becom e relat iv ely cheaper . This
increase in the am ount purchased of X,
because of the fa ll in its relat ive price, is th e
Inc ome chang es , rel ativ e prices of go ods
rem ai ning constan t.

Inc ome rem aini ng th e sam e, the relativ e

prices of good s change.

The firs t is incom e eff ect.

The secon d is subs titut ion ef fe ct.

Pri ce e ffe ct:

Wha t hap pens to consum ers equilibrium as a

result of a change in th e price of one of
the go ods, wh ile his incom e an d the pric e
of th e oth er go od re main the sam e (i.e. the
price ef fect )

There are two compone nts fo r price ef fect:

1. In com e ef fe ct
2. Su bs titut ion ef fect
Whe n th e price of a good X fall, th e rea l
incom e of the cons umer will go up .

The substitut ion eff ec t wil l be po sitive, i. e. if

the pr ice of a good fal ls, more of it wil l be
pur cha sed and substitut ed for the ot her
goo ds whose p ri ce has not f all en.

Bu t wh at about incom e eff ect?

Mor e of such goods may be purc has ed if the
incom e go es up in most goods. But in cases
of som e goods, the inc rease in incom e will
lead to les s p urchase.
The situ ation is :
Bo th sub stitut ion and incom e eff ect will be
positive and bot h in crea se th e dem and of
goo d wh os e pric e has f allen d own.

Su bs titut ion eff ect and incom e ef fe ct wil l pu ll

in oppo site direction. i.e. substitu tion effect
will be po sitive bu t incom e eff ec t will be
neg ative.
The dem and fo r good whose price has fallen
will be altered very little or it can be even
neg ative ou tweighing th e incom e eff ect.
Ordinary In ferior Goo ds :

If the pos it iv e subs ti tut ion ef fec t o ver weighs th e

negati ve eff ec t, the net resu lt woul d be an
inc reas e in the quanti ty of the good bought ,
when its pric e fal ls . This wi ll be so in cas e of
ordinary i nferi or goods .

On the ot her hand, the negat iv e incom e eff ec t

fo r a good is so powerful that it more than
of fs et s the posi tiv e subst it ut ion ef fec t, res ult ing
th e fal l of the quanti ty purc hased, when th e
pric e fal l. Suc h goods are known as “Gif fen
Goods ”.
In ordinary inf erior goods , the negati ve inc ome
ef fec t is weak er than the pos iti ve subs tit ution
ef fec t, re sul ti ng i n dem and i ncreas e.

Gift en goods are spec ial type of inf erior goods

wher e negati ve inco me ef fec t is stronger than
th e pos iti ve subs ti tut ion ef fec t. Where th ere is a
fa ll in demand when pri ce falls .

The fol lowing 3 condi ti ons are es senti al to put a

good i n the category of Gif ten goods .
•It should be an inf er ior good hav ing a lar ge
negati ve i nc ome eff ec t.
•The subs ti tu ti on effect of a pric e change would
be s mall .
•It mus t be an inf erior good, whic h abs orbs a
large pr oportion of a co nsum ers inc ome .

Named aft er Sir Rober t Gif te n, wh o obs erve d

th at the poor brought more bread when its pri ce
rose .
The poor in India buy les s of coarse grain as it s
pric e fal l and buy wheat or ric e.
Fall in pric e of ant iques wo uld reduc e it s
demand.
Elasticity:
The quanti tat iv e rel ati onshi p bet ween pri ce and
quanti ty purc hased is analy zed us ing th e
conc ept of “ Ela st ic it y” .

Price el ast ic ity o f demand.

This is the percenta ge change in quant it y
demanded di vi ded by the perc ent age change in
pric e.

ED = Perc enta ge change in quant it y

demanded
Perc ent age c hange in pr ice
Cat egories of P ri ce Elastici ty:

When a 1% ch ange in pric e cal l for mor e than

1% change in demand, the good is said to have
pric e elas ti c dem and.

When a 1% change in pric e res ult in le ss than

1% change in quant it y dem anded, the good has
pric e in elas ti c dema nd.

When perc ent change in quant it y is ex ac tl y

same as perce ntage ch ange in demand, th e
good i s s ai d t o hav e unit el as ti c demand.
Cas e A : Price = 90; Qty = 240
Cas e B : Price = 110; Qty = 160

Perc ent age pri ce change =

∆P/ P = 20/ 100 = - 2 0%

Perc ent age Qty change = ∆Q/Q = 80/ 200 = -

40%
(ignore t he negati ve s ign)

ED = 40/2 0 = 2
160 D
150
140
130 P2 B
120
110
100
90 P1 A
80
70
60
50 D
40
30
20
10
Q2 Q1
40 80 120 160 200 240 280 320 360
 UNIT ELASTIC
ELASTIC DEMAND
1
1000

500
0.5

1 2 3 1 2

IN-ELASTIC

5 10 15
Dr aw the Dema nd Curv e and calc ulat e the ED.
Calc ulat e Pric e elas tic it y f or t he f oll ow ing:

P Q
6 0 6
Elastic

4 10 4
Unit Elastic

2 20 2
In-elastic

0 30 0 10 20 30 40
Pri ce E las tic ity o f S upply:

The perc ent age change in quant ity supplied

div ided by the per cent age change in pric e.

Es = Perc ent age c hange in quanti ty supplied

Perc ent age c hange in pr ice
Consum er Su rplus :
The Economi c val ue of many goods and serv ic es
wil l be much more than the ac tual pr ice we pay .
For ce rtain comm odit ies , we will be prepare d to
pay muc h mor e than we ac tuall y pay if
alt ernati ve i s to go without them .
Exam ple: Wat er – Ess ent ial commodi ti es –
nec ess iti es

In t he words of Mars hall :

“ The ex ces s of the pr ice whi ch he (i. e.
Consu mer) would be wil li ng to pay rat her than
go wit hout the thing ov er that whic h he act uall y
does pay is the eco nomic meas ur e of thi s
Consu mer surplu s is what we are prepar ed to
pay m inus what we ac tual ly pay.

The gap between the tot al ut il it y of a good and

it s tot al ma rket value is ca lled consum er
sur plus .

The sur pl us aris es bec aus e we “ rece iv e more

th an we pay for” , as a res ult of dim inis hin g
margin al util it y

We pay the same pric e for the 1 st unit and th e

las t uni t though we get hi gher ut il it y for the 1 st
unit , and th e leas t from the last unit for whi ch
 10 Consumer Surplus
9
8
Price 7
MU 6
5
4
3
2
1

1 2 3 4 5 6 7 8
Quantity of Water

He get s a to tal s urplus u ti lit y of :

8+7+6+ 5+4+3+2+1 = 36
Price i s equal to t he m arg inal pric e i .e. Rs. 1/-
The co ncept is us ed for:

3. Econom ic cost benefi t anal ysi s in publi c

inv es tment ; lik e roads , educ at ion, park s,
rese arc h, env ironm ent, health et c.
4. Prici ng t he public goods
5. Tax ati on
6. Welf are ec onomi cs/ welf are state
7. To br ing equity