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Utility Theory

In economics, utility is a measure of relative satisfaction. In other words, it is a term referring to the total
satisfaction received by a consumer from consuming a good or service. Given this measure, one may speak
meaningfully of increasing or decreasing utility, and thereby explain economic behavior in terms of attempts
to increase one's utility. Utility is often modeled to be affected by consumption of various goods and
services, possession of wealth and spending of leisure time.
Cardinal and Ordinal Utility:
Economists distinguish between cardinal utility and ordinal utility. When cardinal utility is used, the
magnitude of utility differences is treated as an ethically or behaviorally significant quantity. On the other
hand, ordinal utility captures only ranking and not strength of preferences.
Utility functions of both sorts assign a ranking to members of a choice set. For example, suppose a cup of
orange juice has utility of 120 utils, a cup of tea has a utility of 80 utils, and a cup of water has a utility of 40
utils. When speaking of cardinal utility, it could be concluded that the cup of orange juice is better than the
cup of tea by exactly the same amount by which the cup of tea is better than the cup of water. One is not
entitled to conclude, however, that the cup of tea is two thirds as good as the cup of juice, because this
conclusion would depend not only on magnitudes of utility differences, but also on the "zero" of utility.
It is tempting when dealing with cardinal utility to aggregate utilities across persons. The argument against
this is that interpersonal comparisons of utility are meaningless because there is no good way to interpret
how different people value consumption bundles.
When ordinal utilities are used, differences in utils are treated as ethically or behaviorally meaningless: the
utility index encode a full behavioral ordering between members of a choice set, but tells nothing about the
related strength of preferences. In the above example, it would only be possible to say that juice is preferred
to tea to water, but no more.

Marginal Utility:
In economics, the marginal utility of a good or service is the utility gained (or lost) from an increase (or
decrease) in the consumptionof that good or service. Economists sometimes speak of a law of diminishing
marginal utility, meaning that the first unit of consumption of a good or service yields more utility than the
second and subsequent units.

Law of Diminishing Marginal Utility:


Definition and Statement of the Law:
The law of diminishing marginal utility describes a familiar and fundamental tendency
of human behavior. The law of diminishing marginal utility states that:
As a consumer consumes more and more units of a specific commodity, the utility from
the successive units goes on diminishing.
Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,
SOA Deemed University, Bhubaneswar, Odisha

Mr. H. Gossen, a German economist, was first to explain this law in 1854. Alfred
Marshal later on restated this law in the following words:
The additional benefit which a person derives from an increase of his stock of a thing
diminishes with every increase in the stock that already has.
Law is Based Upon Three Facts:
The law of diminishing marginal utility is based upon three facts. First, total wants of a
man are unlimited but each single want can be satisfied. As a man gets more and more
units of a commodity, the desire of his for that good goes on falling. A point is reached
when the consumer no longer wants any more units of that good. Secondly, different
goods are not perfect substitutes for each other in the satisfaction of various particular
wants. As such the marginal utility will decline as the consumer gets additional units of a
specific good. Thirdly, the marginal utility of money is constant given the consumers
wealth.
The basis of this law is a fundamental feature of wants. It states that when people go to
the market for the purchase of commodities, they do not attach equal importance to all the
commodities which they buy. In case of some of commodities, they are willing to pay
more and in some less. There are two main reasons for this difference in demand. (1) the
linking of the consumer for the commodity and (2) the quantity of the commodity which
the consumer has with himself. The more one has of a thing, the less he wants the
additional units of it. In other words, the marginal utility of a commodity diminishing as
the consumer gets larger quantities of it. This, in brief, is the axiom of law of diminishing
marginal utility.
Explanation and Example of Law of Diminishing Marginal Utility:
This law can be explained by taking a very simple example. Suppose, a man is very
thirsty. He goes to the market and buys one glass of sweet water. The glass of water gives
him immense pleasure or we say the first glass of water has great utility for him. If he
takes second glass of water after that, the utility will be less than that of the first one. It is
because the edge of his thirst has been blunted to a great extent. If he drinks third glass of
water, the utility of the third glass will be less than that of second and so on.
The utility goes on diminishing with the consumption of every successive glass water till
it drops down to zero. This is the point of satiety. It is the position of consumers
equilibrium or maximum satisfaction. If the consumer is forced further to take a glass of
water, it leads to disutility causing total utility to decline. The marginal utility will
become negative. A rational consumer will stop taking water at the point at which
marginal utility becomes negative even if the good is free. In short, the more we have of a
thing, ceteris paribus, the less we want still more of that, or to be more precise.

Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,


SOA Deemed University, Bhubaneswar, Odisha

In given span of time, the more of a specific product a consumer obtains, the less
anxious he is to get more units of that product or we can say that as more units of a good
are consumed, additional units will provide less additional satisfaction than previous
units. The following table and graph will make the law of diminishing marginal utility
more clear.
Schedule of Law of Diminishing Marginal Utility:
Units
1st glass
2nd glass
3rd glass
4th glass
5th glass
6th glass

Total Utility
20
32
40
42
42
39

Marginal Utility
20
12
8
2
0
-3

From the above table, it is clear that in a given span of time, the first glass of water to a
thirsty man gives 20 units of utility. When he takes second glass of water, the marginal
utility goes on down to 12 units; When he consumes fifth glass of water, the marginal
utility drops down to zero and if the consumption of water is forced further from this
point, the utility changes into disutility (-3).
Here it may be noted that the utility of then successive units consumed diminishes not
because they are not of inferior in quality than that of others. We assume that all the units
of a commodity consumed are exactly alike. The utility of the successive units falls
simply because they happen to be consumed afterwards.
Curve/Diagram of Law of Diminishing Marginal Utility:
The law of diminishing marginal utility can also be represented by a diagram.

Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,


SOA Deemed University, Bhubaneswar, Odisha

In the figure (2.2), along OX we measure units of a commodity consumed and along OY
is shown the marginal utility derived from them. The marginal utility of the first glass of
water is called initial utility. It is equal to 20 units. The MU of the 5th glass of water is
zero. It is called satiety point. The MU of the 6th glass of water is negative (-3). The MU
curve here lies below the OX axis. The utility curve MM/ falls left from left down to the
right showing that the marginal utility of the success units of glasses of water is falling.
Assumptions of Law of Diminishing Marginal Utility:
The law of diminishing marginal utility is true under certain assumptions. These
assumptions are as under:
(i) Rationality: In the cardinal utility analysis, it is assumed that the consumer is rational.
He aims at maximization of utility subject to availability of his income.
(ii) Constant marginal utility of money: It is assumed in the theory that the marginal
utility of money based for purchasing goods remains constant. If the marginal utility of
money changes with the increase or decrease in income, it then cannot yield correct
measurement of the marginal utility of the good.
(iii) Diminishing marginal utility: Another important assumption of utility analysis is
that the utility gained from the successive units of a commodity diminishes in a given
time period.
(iv) Utility is additive: In the early versions of the theory of consumer behavior, it was
assumed that the utilities of different commodities are independent. The total utility of
Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,
SOA Deemed University, Bhubaneswar, Odisha

each commodity is additive.


U = U1 (X1) + U2 (X2) + U3 (X3). Un (Xn)
(v) Consumption to be continuous: It is assumed in this law that the consumption of a
commodity should be continuous. If there is interval between the consumption of the
same units of the commodity, the law may not hold good. For instance, if you take one
glass of water in the morning and the 2nd at noon, the marginal utility of the 2nd glass of
water may increase.
(vi) Suitable quantity: It is also assumed that the commodity consumed is taken in
suitable and reasonable units. If the units are too small, then the marginal utility instead
of falling may increase up to a few units.
(vii) Character of the consumer does not change: The law holds true if there is no
change in the character of the consumer. For example, if a consumer develops a taste for
wine, the additional units of wine may increase the marginal utility to a drunkard.
(viii) No change to fashion: Customs and tastes: If there is a sudden change in fashion or
customs or taste of a consumer, it can than make the law inoperative.
(ix) No change in the price of the commodity: there should be any change in the price
of that commodity as more units are consumed.
Limitations/Exceptions of Law of Diminishing Marginal Utility:
There are some exceptions or limitations to the law of diminishing utility.
(i) Case of intoxicants: Consumption of liquor defies the low for a short period. The
more a person drinks, the more likes it. However, this is truer only initially. A stage
comes when a drunkard too starts taking less and less liquor and eventually stops it.
(ii) Rare collection: If there are only two diamonds in the world, the possession of
2nd diamond will push up the marginal utility.
(iii) Application to money: The law equally holds good for money. It is true that more
money the man has, the greedier he is to get additional units of it. However, the truth is
that the marginal utility of money declines with richness but never falls to zero.
Summing up, we can say that the law of diminishing utility, like other laws of
Economics, is simply a statement of tendency. It holds good provided other factors
remain constant.
Practical Importance of Law of Diminishing Marginal Utility:

Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,


SOA Deemed University, Bhubaneswar, Odisha

The law of diminishing utility has great practical importance in economics. The law of
demand, the theory of consumers surplus, and the equilibrium in the distribution of
expenditure are derived from the law of diminishing marginal utility.
(i) Basis of the law of demand: The law of marginal diminishing utility and the law of
demand are very closely related to each other. In fact they law of diminishing marginal
utility, the more we have of a thing, and the less we want additional increment of it. In
other words, we can say that as a person gets more and more of a particular commodity,
the marginal utility of the successive units begins to diminish. So every consumer while
buying a particular commodity compares the marginal utility of the commodity and the
price of the commodity which he has to pay.
If the marginal utility of the commodity is higher than that of price, he purchases that
commodity. As he buys more and more, the marginal utility of the successive units begins
to diminish. Then he pays fewer amounts for the successive units. He tries to equate at
every step the marginal utility and the price of the commodity, he must lower its price so
that the consumers are induced to buy large quantities and this is what is explained in the
law of demand. From this, we conclude that the law of demand and the law of
diminishing are very closely inter-related.
(ii) Consumers surplus concept: The theory of consumers surplus is also based on the
law of diminishing marginal utility. A consumer while purchasing the commodity
compares the utility of the commodity with that of the price which he has to pay. In most
of the cases, he is willing to pay more than what he actually pays. The excess of the price
which he would be willing to pay rather than to go without the thing over that which he
actually does pay is the economic measure of this surplus satisfaction. It is in fact
difference between the total utility and the actually money spent.
(iii) Importance to the consumer: A consumer in order to get the maximum satisfaction
from his relatively scare resources distributes his income on commodities and services in
such a way that the marginal utility from all the uses are the same. Here again the concept
of marginal utility helps the consumer in arranging his scale of preference for the
commodities and services.
(iv) Importance to finance minister: Some times it is pointed out that the law of
diminishing marginal utility does not apply on money. As a person collects money, the
desires to accumulate more money increases. This view is superficial. It is true that
wealth is acquired for the procurement of goods and services and man is always anxious
in getting more and more of money. But what about the utility of money to him? Is it not
a fact that as a person gets more and more wealth, its utility progressively decreases,
though it does not reach to zero?
For example, a person who earns $90,000 per month attaches less importance to $10. But
a man who gets $1000 per month, the value of $10 to him is very high. A finance minister
knowing this fact that the utility of money to a rich man is high and to poor man low
bases the system of taxation in such a way that the rich persons are taxed at a progressive
Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,
SOA Deemed University, Bhubaneswar, Odisha

rate. The system of modern taxation is therefore, based on the law of diminishing
marginal utility.

Consumer Equilibrium
When consumers make choices about the quantity of goods and services to consume, it is
presumed that their objective is to maximize total utility. In maximizing total utility,
the consumer faces a number of constraints, the most important of which are the
consumer's income and the prices of the goods and services that the consumer wishes to
consume. The consumer's effort to maximize total utility, subject to these constraints, is
referred to as the consumer's problem. The solution to the consumer's problem, which
entails decisions about how much the consumer will consume of a number of goods and
services, is referred to as consumer equilibrium.
Determination of consumer equilibrium. Consider the simple case of a consumer who
cares about consuming only two goods: good 1 and good 2. This consumer knows the
prices of goods 1 and 2 and has a fixed income or budget that can be used to purchase
quantities of goods 1 and 2. The consumer will purchase quantities of goods 1 and 2 so
as to completely exhaust the budget for such purchases. The actual quantities purchased
of each good are determined by the condition for consumer equilibrium, which is

This condition states that the marginal utility per dollar spent on good 1 must equal the
marginal utility per dollar spent on good 2. If, for example, the marginal utility per dollar
spent on good 1 were higher than the marginal utility per dollar spent on good 2, then it
would make sense for the consumer to purchase more of good 1 rather than purchasing
any more of good 2. After purchasing more and more of good 1, the marginal utility of
good 1 will eventually fall due to the law of diminishing marginal utility, so that the
marginal utility per dollar spent on good 1 will eventually equal that of good 2. Of course,
the amount purchased of goods 1 and 2 cannot be limitless and will depend not only on
the marginal utilities per dollar spent, but also on the consumer's budget.

Law of Equi-Marginal Utility:


(Equilibrium of the Consumer Through the Law of Equi-Marginal Utility):
Other Names of this Law:

Law of Substitution OR Law of Maximum Satisfaction OR Law of


Indifference OR Proportion Rule OR Gossen's Second Law.
In the cardinal utility analysis, the principle of equal marginal utility occupies an important place.

Definition and Statement of Law of Equi-Marginal Utility:


Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,
SOA Deemed University, Bhubaneswar, Odisha

The law of equi-marginal utility is simply an extension of law of diminishing marginal utility to
two or more than two commodities. The law of equilibrium utility is known, by various names. It is
named as the Law of Substitution, the Law of Maximum Satisfaction, the Law of Indifference, the
Proportionate Rule and the Gossens Second Law.
In cardinal utility analysis, this law is stated by Lipsey in the following words:
The household maximizing the utility will so allocate the expenditure between commodities that
the utility of the last penny spent on each item is equal.
As we know, every consumer has unlimited wants. However, the income this disposal at any time
is limited. The consumer is, therefore, faced with a choice among many commodities that he can
and would like to pay. He, therefore, consciously or unconsciously compress the satisfaction
which he obtains from the purchase of the commodity and the price which he pays for it. If he
thinks the utility of the commodity is greater or at-least equal to the loss of utility of money price,
he buys that commodity.
As he buys more and more of that commodity, the utility of the successive units begins to
diminish. He stops further purchase of the commodity at a point where the marginal utility of the
commodity and its price are just equal. If he pushes the purchase further from his point of
equilibrium, then the marginal utility of the commodity will be less than that of price and the
household will be loser. A consumer will be in equilibrium with a single commodity symbolically:
MUx = Px
A prudent consumer in order to get the maximum satisfaction from his limited means compares
not only the utility of a particular commodity and the price but also the utility of the other
commodities which he can buy with his scarce resources. If he finds that a particular expenditure
in one use is yielding less utility than that of other, he will tie to transfer a unit of expenditure from
the commodity yielding less marginal utility. The consumer will reach his equilibrium position
when it will not be possible for him to increase the total utility by uses. The position of equilibrium
will be reached when the marginal utility of each good is in proportion to its price and the ratio of
the prices of all goods is equal to the ratio of their marginal utilities.
The consumer will maximize total utility from his income when the utility from the last rupee spent
on each good is the same. Algebraically, this is:
MUa / Pa = MUb / Pb = MUc / Pc = MUn / Pn
Here: (a), (b), (c). (n) are various goods consumed.

Assumptions of Law of Equi-Marginal Utility:


The main assumptions of the law of equi-marginal utility are as under.
(i) Independent utilities. The marginal utilities of different commodities are independent of each
other and diminish with more and more purchases.
(ii) Constant marginal utility of money. The marginal utility of money remains constant to the
consumer as he spends more and more of it on the purchase of goods.

Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,


SOA Deemed University, Bhubaneswar, Odisha

(iii) Utility is cardinally measurable.


(iv) Every consumer is rational in the purchase of goods.

Example and Explanation of Law of Equi-Marginal Utility:


The doctrine of equi-marginal utility can be explained by taking an example. Suppose a person
has $5 with him whom he wishes to spend on two commodities, tea and cigarettes. The marginal
utility derived from both these commodities is as under:

Schedule:
Units of Money
1
2
3
4
5
$5

MU of Tea
10
8
6
4
2
Total Utility = 30

MU of Cigarettes
12
10
8
6
3
Total Utility = 30

A rational consumer would like to get maximum satisfaction from $5.00. He can spend money in
three ways:
(i) $5 may be spent on tea only.
(ii) $5 may be utilized for the purchase of cigarettes only.
(iii) Some rupees may be spent on the purchase of tea and some on the purchase of cigarettes.
If the prudent consumer spends $5 on the purchase of tea, he gets 30 utility. If he spends $5 on
the purchase of cigarettes, the total utility derived is 39 which are higher than tea. In order to
make the best of the limited resources, he adjusts his expenditure.
(i) By spending $4 on tea and $1 on cigarettes, he gets 40 utility (10+8+6+4+12 = 40).
(ii) By spending $3 on tea and $2 on cigarettes, he derives 46 utility (10+8+6+12+10 = 46).
(iii) By spending $2 on tea and $3 on cigarettes, he gets 48 utility (10+8+12+10+8 = 48).
(iv) By spending $1 on tea and $4 on cigarettes, he gets 46 utility (10+12+10+8+6 = 46).
The sensible consumer will spend $2 on tea and $3 on cigarettes and will get maximum
satisfaction. When he spends $2 on tea and $3 on cigarette, the marginal utilities derived from
both these commodities is equal to 8. When the marginal utilities of the two commodities are
equalizes, the total utility is then maximum, i.e., 48 as is clear from the schedule given above.

Curve/Diagram of Law of Equi-Marginal Utility:


Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,
SOA Deemed University, Bhubaneswar, Odisha

The law of equi-marginal utility can be explained with the help of diagrams.

In the figure 2.3 MU is the marginal utility curve for tea and KL of cigarettes. When a consumer
spends OP amount ($2) on tea and OC ($3) on cigarettes, the marginal utility derived from the
consumption of both the items (Tea and Cigarettes) is equal to 8 units (EP = NC). The consumer
gets the maximum utility when he spends $2 on tea and $3 on cigarettes and by no other
alternation in the expenditure.
We now assume that the consumer spends $1 on tea (OC/ amount) and $4 (OQ/) on cigarettes. If
CQ/more amounts are spent cigarettes, the added utility is equal to the area CQ / N/N. On the
other hand, the expenditure on tea falls from OP amount ($2) to OC / amount ($1). There is a toss
of utility equal to the area C/PEE. The loss is utility (tea) is greater than that The loss in utility (tea)
is maximum satisfaction except the combination of expenditure of $2 on tea and $3 on cigarettes.
This law is known as the Law of maximum Satisfaction because a consumer tries to get the
maximum satisfaction from his limited resources by so planning his expenditure that the
marginal utility of a rupee spent in one use is the same as the marginal utility of a rupee
spent on another use.
It is known as the Law of Substitution because consumer continuous substituting one good for
another till he gets the maximum satisfaction.
It is called the Law of Indifference because the maximum satisfaction has been achieved by
equating the marginal utility in all the uses. The consumer than becomes indifferent to
readjust his expenditure unless some change fakes place in his income or the prices of the
commodities, etc.

Limitations/Exceptions of Law of Equi-Marginal Utility:


Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,
SOA Deemed University, Bhubaneswar, Odisha

(i) Effect on fashions and customs: The law of equi-marginal utility may become inoperative if
people forced by fashions and customs spend money on the purchase of those commodities
which they clearly knows yield less utility but they cannot transfer the unit of money from the less
advantageous uses to the more advantageous uses because they are forced by the customs of
the country.
(ii) Ignorance or carelessness: Sometimes people due to their ignorance of price or
carelessness to weigh the utility of the purchased commodity do not obtain the maximum
advantage by equating the marginal utility in all the uses.
(iii) Indivisible units: If the unit of expenditure is not divisible, then again the law may become
inoperative.
(iv) Freedom of choice: If there is no perfect freedom between various alternatives, the
operation of law may be impeded.

Importance of Law of Equi-Marginal Utility:


The law of equi-marginal utility is of great practical importance. The application of the principle of
substitution extends over almost every field of economic enquiry. Every consumer consciously
trying to get the maximum satisfaction from his limited resources acts upon this principle of
substitution. Same is the case with the producer. In the field of exchange and in theory of
distribution too, this law plays a vital role. In short, despite its limitation, the law of maximum
satisfaction is meaningful general statement of how consumers behave.
In addition to its application to consumption, it applies equally to the theory of production and
theory of distribution. In the theory of production, it is applied on the substitution of various factors
of production to the point where marginal return from all the factors are equal. The government
can also use this analysis for evaluation of its different economic prices.
The equal marginal rule also guides an individual in the spending of his saving on different types
of assets. The law of equal marginal utility also guides an individual in the allocation of his time
between work and leisure. In short, despite limitations the law of substitution is applied to all
problems of allocation of scarce resources.

INDIFFERENCE CURVE ANALYSIS


In the last section we discussed marginal utility analysis of demand. A very
popular alternative and more realistic method of explaining consumer's demand is the
Indifference Curve Analysis. This approach to consumer behaviour is based on consumer
preferences. It believes that human satisfaction being a psychological phenomenon
cannot be measured quantitatively in monetary terms as was attempted in Marshall's
utility analysis. In this approach it is felt that it is much easier and scientifically more
sound to order preferences than to measure them in terms of money.
The consumer preference approach, is, therefore an ordinal concept based on ordering of
preferences compared with Marshall's approach of cardinality.
Assumptions Underlying Indifference Curve Approach
1. The consumer is rational and possesses full information about all the relevant
aspects of economic environment in which he lives.
2. The consumer is capable of ranking all conceivable combinations of goods
according to the satisfaction they yield. Thus if he is given various combinations
Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,
SOA Deemed University, Bhubaneswar, Odisha

say A, B, C, D, E he can rank them as first preference, second preference and so


on.
3. If a consumer happens to prefer A to B, he can not tell quantitatively how much
he prefers A to B.
If the consumer prefers combination A to B, and B to C, then he must prefer
combination A to C. In other words, he has consistent consumption pattern
behaviour.
5. If combination A has more commodities than combination B, then A must be
preferred to B.
What are Indifference Curves? Ordinal analysis of demand (here we will discuss the
one given by Hicks and Allen) is based on indifference curves. An indifference curve is a
curve which represents all those combinations of goods which give same satisfaction to
the consumer. Since all the combinations on an indifference curve give equal satisfaction
to the consumer, the consumer is indifferent among them. In other words, since all the
combinations provide same level of satisfaction the consumer prefers them equally and
does not mind which combination he gets.
To understand indifference curves let us consider the example of a consumer who
has one unit of food and 12 units of clothing. Now we ask the consumer how many units
of clothing he is prepared to give up to get an additional unit of food, so that his level of
satisfaction does not change. Suppose the consumer says that he is ready to give up 6
units of clothing to get an additional unit of food. We will have then two combinations of
food and clothing giving equal satisfaction to consumer: Combination A has 1 unit of
food and 12 units of clothing, combination B has 2 units of food and 6 units of clothing.
Similarly, by asking the consumer further how much of clothing he will be prepared to
forgo for successive increments in his stock of food so that his level of satisfaction
remains unaltered, we get various combinations as given below:
Table Indifference Schedule
Table 2
Combination
Food
Clothing
MRS
A
1
12
B
2
6
6
C
3
4
2
D
4
3
1
Now if we draw the above schedule we will get the following figure.
In Figure 8, an indifference curve IC is drawn by plotting the various combinations of the
indifference schedule. The quantity of food is measured on the X axis and the quantity of
clothing on the Y axis. As in indifference schedule, combinations lying on an
indifference curve will give the consumer same level of satisfaction.

Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,


SOA Deemed University, Bhubaneswar, Odisha

Fig. 8 : A Consumer's Indifference Curve

Indifference Map: A set of indifference curves is called indifference map.


An indifference map depicts complete picture of consumer's tastes and
preferences.
Marginal Rate of Substitution: Marginal Rate of Substitution (MRS) is the rate
at which the consumer is prepared to exchange goods X and Y Consider Table-2. In the
beginning the consumer is consuming 1 unit of food and 12 units of clothing.
Subsequently, he gives up 6 units of clothing to get an extra unit of food, his level of
satisfaction remaining the same. The MRS here is 6. Like wise which he moves from B to
C and from C to D in his indifference schedule, the MRS are 2 and 1 respectively. Thus,
we can define MRS of X for Y as the amount of Y whose loss can just be compensated
by a unit gain of X in such a manner that the level of satisfaction remains the same. We
notice that MRS is falling i.e., as the consumer has more and more units of food, he is
prepared to give up less and less units of cloths. There are two reasons for this.
1. The want for a particular good is satiable so that when a consumer has its
more quantity, his intensity of want for it decreases. Thus, when consumer in
our example, has more units of food, his intensity of desire for additional units
of food decreases.
2. Most of the goods are imperfect substitutes of one another. If, they could
substitute one another perfectly. MRS would remain constant.
Properties of Indifference Curves: The following are the main characteristics or
properties of indifference curves :
(i) Indifference curves slope downward to the right: This property implies that when
the amount of one good in combination is increased, the amount of the other good is
reduced. This is essential if the level of satisfaction is to remain the same on an
indifference curve.
(ii) Indifference curves are always convex to the origin: It has been observed that as
more and more of one commodity (X) is substituted for another (Y), the consumer is
willing to part with less and less of the commodity being substituted (i.e. Y). This is
called diminishing marginal rate of substitution. Thus in our example of food and
clothing, as a consumer has more and more units of food, he is prepared to forego less
and less units of clothing. This happens mainly because want for a particular good is
satiable and as a person has more and more of a good, his intensity of want for that good
goes on diminishing. This diminishing marginal rate of substitution gives convex shape
to the indifference curves. However, there are two extreme situations. When two goods
are perfect substitutes of each other, the indifference curve is a straight line on which
MRS is constant. And when two goods are perfect complementary goods (e.g. gasoline
Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,
SOA Deemed University, Bhubaneswar, Odisha

and water in a car), the indifference curve will consist of two straight line with a right
angle bent which is convex to the origin or in other words, it will be L shaped.
(iii) Indifference curves can never intersect each other: No two indifference curves
will intersect each other although it is not necessary that they are parallel to each other. In
case of intersection the relationship becomes logically absurd because it would show that
higher and lower levels are equal which is not possible. This property will be clear from
the following Figure 13.

In figure 13, IC1, and IC2 intersect at A. Since A and B lie on IC1, they give same
satisfaction to the consumer. Similarly since A and C lie on IC2, they give same
satisfaction to the consumer. This implies that combination B and C are equal in terms of
satisfaction. But a glance will show that this is an absurd conclusion because certainly
combination C is better than combination B because it contains more units of
commodities X and Y. Thus we see that no two indifference curves can touch or cut each
other.
(iv) A higher indifference curve represents a higher level of satisfaction than the
lower indifference curve: This is because combinations lying on a higher indifference
curve contain mere of either one or both goods and more goods are preferred to less of
them.
Budget line : A higher indifference curve shows a higher level of satisfaction than a
lower one. Therefore, a consumer in his attempt to maximise satisfaction will try to reach
the highest possible indifference curve. But in his pursuit of buying more and more goods
and thus obtaining more and more satisfaction he has to work under two constraints :
firstly, he has to pay the prices for the goods and, secondly, he has a limited money
income with which to purchase the goods.
These constraints are explained by budget line or price line. In simple words a
budget line shows all those combinations of two goods which the consumer can buy
spending his given money income on the two goods at their given prices. All those
combinations which are within the reach of the consumer (assuming that he spends all his
money income) will lie on the budget line.

Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,


SOA Deemed University, Bhubaneswar, Odisha

Consumers Equilibrium: Having explained indifference curves and budget line, we


are in a position to explain how a consumer reaches equilibrium position. A consumer is
in equilibrium when he is deriving maximum possible satisfaction from the goods and is
in no position to rearrange his purchases of goods. We assume that :
(i)the consumer has a given indifference map which shows his scale of preferences for
various combinations of two goods X and Y.
(ii)he has a fixed money income which he has to spend wholly on goods X and Y.
(iii)prices of goods X and Y are given and are fixed for him.
To show which combination of two goods X and Y the consumer will buy to be in
equilibrium we bring his indifference map and budget line together.
We know by now, that the indifference map depicts the consumers preference
scale between various combinations of two goods and the budget line shows various
combinations which he can afford to buy with his given money income and prices
of the two goods. Consider Figure 15, in which IC1, IC2, IC3, IC4 and IC5 are shown
together with budget line PL for good X and good Y. Every combination on budget line
PL costs the same. Thus combinations R, S, Q, T and H cost the same to the consumer.
The consumers aim is to maximize his satisfaction and for this he will try to reach
highest indifference curve.

But since there is a budget constraint he will be forced to remain on the given budget line,
that is he will have to choose any combinations from among only those which lie on the
given price line.
Which combination will he choose? Suppose he chooses R, but we see that R lies on a
lower indifference curve IC1, when he can very well afford S, Q or T lying on higher
Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,
SOA Deemed University, Bhubaneswar, Odisha

indifference curve. Similar is the case for other combinations on IC 1, like H. Again,
suppose he chooses combination S (or T) lying on IC2. But here again we see that the
consumer can still reach a higher level of satisfaction remaining within his budget
constraints i.e., he can afford to have combination Q lying on IC 3 because it lies on his
budget line. Now what if he chooses combination Q? We find that this is the best choice
because this combination lies not only on his budget line but also puts him on highest
possible indifference curve i.e., IC3 The consumer can very well wish to reach IC 4 or IC5,
but these indifference curves are beyond his reach given his money income. Thus the
consumer will be at equilibrium at point Q on IC 3. What do we notice at point Q? We
notice that at this point, his budget line PL is tangent to the indifference curve IC 3. In this
equilibrium position (at Q), the consumer will buy OM of X and ON of Y
At the tangency point Q, the slopes of the price line PL and indifference curve
IC3 are equal. The slope of the indifference curve shows the marginal rate of substitution
of X for Y (MRSxy), which is equal to MU x / MU y, while the slope of the price line
indicates the ratio between the prices of two goods i.e., Px / Py
At equilibrium point Q, MRSxy = MU x / MU y = Px / Py.
Thus, we can say that the consumer is in equilibrium position when price line is tangent
to the indifference curve or when the marginal rate of substitution of goods X and Y is
equal to the ratio between the prices of the two goods.

Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,


SOA Deemed University, Bhubaneswar, Odisha