UNIVERSITY OF GUJRAT

DEPARTMENT:
BUSINESS ADMINISTRATION
The TOPIC on which we are going to present
is
CONSUMER EQILIBRIUM
 UTILITY THEORY

UTILITY :
ØA measure of satisfaction (happiness or benefit) that
results from consuming a good.
OR
ØUtility is the Power of a Commodity to satisfy human wants.

APPROACHES TO UTILITY:

There are two different approaches to the utility theory.

1.Cardinal approach to utility analysis.

2. Ordinal approach to utility analysis.
 CARDINAL APPROACH

ØThis School believes that Utility is Measurable and is a

Quantifiable entity.
ØCardinal Approach gives exact measurement by assigning
definite numbers such as 1, 2, 3, etc.
Ø
ØCardinal utility believes that utility could be measured and
added.
 ASSUMPTIONS OF THE CARDINAL
APPROACH OF UTILITY

1. Cardinal Measurement of Utility

2. Utilities are Independent

1.
3. Constant Marginal Utility of Money
1.
4. Introspection
 TOTAL UTILITY AND MARGINAL
UTILITY

TOTAL UTILITY:
Total Utility is the sum total of the units of utility which an
individual derives from the consumption of a commodity during a
specified period of time.

MARGINAL UTILITY:
Marginal Utility is the change in the total utility resulting from a
one-unit change in the consumption of a commodity per unit of
time.
Marginal Utility is the addition made to the total utility by the
consumption of the last unit considered just worthwhile.
MARGINAL UTILITY is given by the formula:

MU = Change in Total Utility

Change in Quantity Consumed

i.e.

MU = ΔTU
ΔQ
RELATIONSHIP BETWEEN TOTAL
UTILITY AND MARGINAL UTILITY

ØTotal Utility starts increasing by decreasing ratio

while Marginal Utility starts decreasing.
ØWhen Total Utility is at its maximum point and
thereafter starts decreasing, Marginal Utility comes to
zero.
ØAfter the maximum point has been achieved by total
utility it starts decreasing which causes marginal
utility to become negative
A Hypothetical Utility Schedule:

Units(x) Total utility Marginal utility

0 0 ---
1 20 20
2 27 7
3 32 5
4 35 3
5 35 0
6 34 -1
THE TABLE SHOWS THAT AS:

ØTotal utility is rising as more X is consumed

(TU is increasing in X).
Ø
ØMarginal utility is falling as more X is
consumed (MU is decreasing in X).
Ø
ØFrom X = 1 onwards, MU is declining that
gives us the law of diminishing marginal utility.
Total Utility Curve
TU

35
Total utility(in utils)

30
25
20
15
10
5
Q
0 1 2 3 4 5 6
Quantity
 Marginal Utility Curve
MU
Y-axis
Marginal utility (in utils)

20
15
10

5
0 Q
1 2 3 4 5 6 X-axis
-5
Quantity
 TOTAL AND MARGINAL UTILITY
TU
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)

per meal Utils Utils
20
0 0
1 10 10 10

2 18 8
3 24 6
4 28 4 0 1 2 3 4 5 6 7

5 30 2 Units consumed per meal

Marginal Utility (utils)

10

6 30 0 8
6

7 28 -2 4
2
0
-2 MU
1 2 3 4 5 6 7
Units consumed per meal
 LAW OF EQUI-MARGINAL
UTILITY

ØIt is an extension of the law of Diminishing Marginal

Utility to two or more commodities.
ØGiven the income of a consumer, the law states that
consumer can get maximum satisfaction when the
Marginal Utility of the last rupee spent on each
commodity yield the same utility.
ØTo get maximum satisfaction, consumer will substitute
one good for another.
ØIt is also called as Law of Substitution, Law of
Indifference, or Law of Maximum Satisfaction.
ØThe consumer will spend his money
income on different goods in such a
way that marginal utility of each good
is proportional to its price.

ØThe principle of equi-marginal

utility explains the behavior of a
consumer in distributing his limited
income among various goods and
services.
Assumptions

The principle of equi-marginal utility

is based on the following
assumptions:
(a) The wants of a consumer remain
unchanged.
(b) He has a fixed income.
(c) The prices of all goods are given
and known to a consumer.
(d) He is one of the many buyers in the sense
that he is powerless to alter the market price.
(e) He can spend his income in small amounts.
(f) He acts rationally in the sense that he want
maximum satisfaction
(g) Utility is measured cardinally. This means
that utility, or use of a good, can be expressed
in terms of "units" or "utils". This utility is not
only comparable but also quantifiable.
7.2 Consumer Choice

E. An Illustration of the Equi-marginal Rule

Converting Marginal Utility to Marginal Utility per Dollar:
Table 7.2 Price of Pizza = $2 , Price of a Cup of Coke = $1

(1) (2) (3) (4) (5) (6)

Slices Marginal Marginal Cans Marginal Marginal
of Pizza Utility Utility of Coke Utility Utility
(MUPizza ) per Dollar (MUCoke ) per Dollar
1 20 10 1 20 20
2 16 8 2 15 15

3 10 5 3 10 10
4 6 3 4 5 5
5 2 1 5 3 3
6 3 -- 6  1 --

Consumers maximize their total utility when the marginal utility of the last
dollar spent on each good is equal for all goods.
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7.2 Consumer Choice

E. An Illustration of the Equi-marginal Rule (Cont.)

Combinations of Pizza and Coke Marginal Total Spending Total Utility
1 Slice
with of Pizza
Equal and 3Utilities
Marginal Cans ofper 10
Utility per $2 + $3 = $5 20 + 45 = 65
Coke
Dollar Dollar
3 Slices of Pizza and 4 Cans of 5
(Marginal $6 + $4 = $10 46 + 50 = 96
4 Slices of Pizza and 5 Cans of
Coke 3
Utility/Price) $8 + $5 = $13 52 + 53 = 105
Coke

If the consumer’s budget is $10, what combination will be

chosen? The solution must satisfy these conditions:
1.

2. Spending on pizza + Spending on Coke = Amount available for

spending.
21
 FORMULA FOR CONSUMER
EQUILIBRIUM
•
• Under Law of Equi-marginal utility consumer
equilibrium can be stated in the following formula.
•
•
 MUx = MUy = …… MUn
 Px Py Pn
 EXAMPLE
• Suppose consumer is buying two Goods X and Y and
marginal utility of them are given as
•
•Units of X & Y MU x MU y
•
1 33 36
•
•2 30 32
•3 27 28
•4 24 24
•5 21 20
•6 18 16
ØSuppose that the prices of good X & Y
are Rs. 3 & Rs.4 respectively and total
income is Rs.20. The above table can be
reconstructed by dividing the marginal
utilities of good X by Rs. 3 and marginal
utilities of good y by Rs. 4.
The Resulting Marginal Utility Table

Units of Money MU x MU y
Px Py
1 11 9
2 10 8
3 9 7
4 8 6
5 7 5
6 6 4
EXAMPLE:
If both water and diamond were free goods, there
would be no discrepancies at all between their
MU's. As
long as the MU of either goods remains positive,
one's utility can increase simply by increasing its
consumption. Any increase in its consumption in
turn decreases its MU (why?) until it vanishes,
when its
total utility is maximized (why?).So far as the two
goods are concerned, the consumer would be fully
satiated when their two MUs become both zero.
However both MUs remain positive
because neither water nor diamond is a
free good. This can be explained by the
law of equimarginal utility which tells how
much of each
good should the consumer buy for
consumption.
Let us further explain the example of
water and diamond:

Their MUs per dollar can be denoted

respectively as MUW/pW and MUD/pD where p
stands for
price per unit quantity, and the subscripts W and
D refer to water and diamond, respectively.
Using these
symbols, we can now state the law as:
(MUW/pW) = (MUD/pD).
The law of equi-MU underscoring
this equation states in effect that
the MU of water divided by the
price
of water must be equal to the MU
of diamond divided by the price of
diamond so far as the consumer is
optimizing his/her consumption of
the two goods.
Some simplifying assumptions

• Consumer’s objective: to maximize

his/her utility subject to income
constraint.
• 2 goods (X, Y)
• Prices Px, Py are fixed
• Consumer’s income (I) is given
Simple Illustration

• Suppose: X = fishball
Y = siomai

• Assume: PX= 2
PY = 10
Numerical Illustration

Qx TUX MUX MUx QY TUY MUY MUy

Px Py

1 30 30 15 1 50 50 5
2 39 9 4.5 2 105 55 5.5

3 45 6 3 3 148 43 4.3

4 50 5 2.5 4 178 30 3

5 54 4 2 5 198 20 2

6 56 2 1 6 213 15 1.5
2 potential optimum positions
Combination A:  X = 3 and Y = 4
 TU = TUX + TUY = 45 + 178 = 223
Combination B:  X = 5 and Y = 5


 TU = TUX + TUY = 54 + 198 = 252

• Presence of 2 potential equilibrium
positions suggests that we need to
consider income. To do so let us
examine how much each consumer
spends for each combination.
• Expenditure per combination
– Total expenditure = PX X + PY Y
– Combination A: 3(2) + 4(10) = 46
– Combination B: 5(2) + 5(10) = 60
• Scenarios:
– If consumer’s income = 46, then the
optimum is given by combination A. .
…Combination B is not affordable
– If the consumer’s income = 60, then
the optimum is given by
Combination B….Combination A is
affordable but it yields a lower level
of utility.
LIMITATIONS OF THE LAW
•
• Rationality
• Effects of Fashion and Customs
• Ignorance
• Indivisible Units
• Questionable Assumptions
•
ØThis law is not applicable in the case
of indivisible goods like TV sets,
refrigerators, etc. Normally a person
will buy only a single unit of such
goods. Hence it is ridiculous to
prepare an individual marginal utility
schedule for such goods.
PRACTICAL IMPORTANCE OF THE LAW

• Applications to Consumption
• Applications to Production
• Applications to Exchange
• Price Determination
• Applications to Distribution
Consumer Equilibrium and the Law of
Demand

ØWe want to demonstrate that consumer’s utility maximization is

consistent with the law of demand.

ØImagine that a consumer is initially at an equilibrium:

MUx = MUy
Px Py

ØNow, suppose that the price of X rises to P0 , so that:

MUx < MUy

P0 Py
ØThe consumer restores equilibrium by
redirecting some dollars from X to Y .

Y↑» MUy ↓and X ↓»MUx ↑

until the equilibrium condition is

restored.

ØThis behavior is consistent with the

law of demand : : :

Px ↑»QDx ↓
The Law of Demand

That the consumer optimum is

attained under the law or conditions of
equi-marginal utility per
dollar means that the quantity of
demand for diamond, water or
anything else is corresponding to its
price
(as well as other prices.) The demand
as a schedule is nothing but the
correspondence between the
quantity of demand and its price,
ceteris paribus.
law of demand can be derived formally from the law
of equi-marginal utility and the law of diminishing
MU. Without loss of generality let us consider the
demand for diamond. Suppose that the price of
diamond declined. Then MU of diamond per dollar
must
increase. (Why?) More diamond can be consumed
accordingly (and less water perhaps). As more
diamond is consumed its MU tends to decline due to
the law of diminishing MU until when a new state of
equi-marginal utility is obtained. The quantity of
diamond willingly purchased is larger at the new
optimum than it is at the old optimum under a given
budget constraint. This proves the law of demand.
 THE INDIVIDUAL DEMAND CURVE
An individual demand curve shows the relationship between the price of
a product and the quantity demanded by a rational consumer. In other
words, the demand curve shows, for each price, the utility-maximizing
quantity for the consumer.

The Individual Demand Curve

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 Limitations:

ØIt is based on the unrealistic assumption of cardinal measurement of

utility. Utility is a psychological term which can not be measured in terms of
numbers and units.

ØIt is applicable only for one commodity.

ØIt does not explain the impact of the complementary and substitute goods
on the demand.

ØIt can not explain the impact of changes in the income on demand .
Ø