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Assignment on Consumer Equilibrium and Demand Curve

Assignment:

Explain on the basis of Indifference Curve Analysis, how a consumer attains equilibrium
in his purchase decision? Derive the Demand Curve from that analysis.

Solution:

An Indifference Curve reveals the various combinations of two products or services to


which the customer is indifferent at a particular level of income. Any combination of
products or services on an indifference curve will give the same level of utility. The
indifference curve is based on the following assumptions:

• Indifference curves have a negative slope


Indifference curve slopes downward to the right, which reveals that the consumer
prefers more of a particular product. Given the choice between two products in an
indifference curve, if the consumer displays decreased demand for one product,
naturally the demand for the other product goes up.

• Indifference curves cannot intersect each other


If indifference curves intersect each other, it means that a consumer has two
different levels of utility for the two products. Higher level of indifference curve shows
higher levels of utility.

This concept can be explained with the help of Marginal Rate of substitution:

The Marginal Rate of Substitution (MRS) is the rate at which a customer is willing to
substitute one product for the other maintaining the same level of utility.

The Ratio of the Marginal Utility of the two products and the rate at which a consumer is
willing to trade one product for another can be derived by measuring the marginal rate of
substitution between them keeping the Total Utility constant.

To explain the concept better, let’s take the example of two products – pastry and patties.
Consuming an additional unit of patties causes total utility to increase while the marginal
utility is positive. On the other hand, reducing the consumption of pastries causes total
utility to decrease, marginal utility being negative. For total utility to remain unchanged, the
gain in total utility due to the increased consumption of patties must exactly offset the
reduction in total utility due to the reduced consumption of pastries.

Consumption of two Products that yield same level of utility

Utility Quantity of Pastries Consumed Quantity of Patties Consumed


20 11 2
20 9 6
20 6 9
20 2 11

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Assignment on Consumer Equilibrium and Demand Curve

The change in total utility is equal to the change in the number of units consumed multiplied
by the marginal utility of each of those units. The consumption of additional units of patties
and reduced consumption for pastries, keeping the total utility constant can be expressed
as

Pd pastries * MU pastries + Pd Pastries * MU Patties = 0

Because PdS is negative, the previous equation can be written as

Pd pastries * MU pastries =Pd Pastries * MU Patties

The above equation can be also expressed as:

MU pastries / MU Patties = Pd patties /Pd Pastries

The left-hand side of the above equation finds the ratio of the Marginal Utility of pastries
divided by the marginal utility of patties or the marginal rate of substitution of pastries for
patties. The right-hand side of the equation tells us the number of patties the consumer is
willing to give up to purchase an additional unit of pastries.

Budget Constraint

The term Budget Constraint implies that the income of consumer is limited and he/she
spent total money or maximum amount of money on consuming the products.

The budget constraint can be expressed for the above mentioned products as:

Available money income for consumption >= Price of pastries * Quantity of pastries +
Price of patties * Quantity of patties

Consumer Equilibrium

A consumer is said to be in equilibrium when he maximizes his satisfaction with the


available money income. Individuals maximizing utility subject to their budget constraint
attain the highest possible level of utility at a point of tangency between their budget
constraint and an indifference curve. The budget line represents the fixed income available
to the consumer to spend on two products. The intercepts of this budget constraint on each
axis (X and Y) equals income divided by the price of the product. Here, consumer
satisfaction is measured in terms of the preference or ranking he gives for the consumption
of products and services. Preference is represented in the form of indifference curve. The
consumer can reach his equilibrium level when the indifference curve is tangential to
budget line.

This can be represented graphically as:

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Assignment on Consumer Equilibrium and Demand Curve

The equilibrium point is reached when the consumer consumes X* units of product X and
Y* units of product Y. other points on the budget constraint, such as point A and B are
feasible, but not optimum, even through Point B provides a higher level of utility with
regards to Product X, and A with regard to Product Y.

Derivation of Demand Curve:

From the above discussion the demand curve can be derived graphically as:

Sujeet Kumar MBA 1st Semester Roll No. 25


Assignment on Consumer Equilibrium and Demand Curve

Fig. Derivation of Demand Curve

After determining the consumer equilibrium, we may say that a certain quantity of Product X
and Product Y will satisfy the consumer as per the budget line. Form the above discussion;
we may derive the demand curve by keeping constant the product Y.

As per the law of Demand sates that other things reaming constant, quantity demanded of a
commodity increases with a falling price and diminishes when price increases. Where other
things could be:

• Taste and preference of the customer remain constant.


• There is no change in the income of the consumer.
• Prices of the related goods do not change.
• Consumer doesn’t aspect any change in the price of the commodity in near future.

After making the following assumption, when we change the price of the commodity X the
demand for the commodity X also changes. The changes could be recorded/observed as:

• Increase in the price of Product X; decrease in its quantity demanded.


• Decrease in the price of Product X; increase in its quantity demanded.

The above trend is observed because of the assumption of Budget Constraint as consumer
doesn’t want or can’t change his/her Budget level (as per assumption of ‘other things’ in law
of demand). The curve ABC is said to be Demand Curve of Product X.

So, in this way, we may conclude that:

Price of a commodity is inversely related to its quantity demanded, being ‘other things’
remain constant.

Sujeet Kumar MBA 1st Semester Roll No. 25