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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:
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.
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
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
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.
From the above discussion the demand curve can be derived graphically as:
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:
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:
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.
Price of a commodity is inversely related to its quantity demanded, being ‘other things’
remain constant.