Consumer's Equilibrium and Demand

The One Thing

Consumer theory explains how individuals allocate limited income to maximise satisfaction and how their purchases respond to changes in prices, income, related goods and other determinants. Utility and indifference-curve analysis explain equilibrium, while demand and elasticity analyse changes in quantity purchased.

Who and What

• Utility: The want-satisfying power or satisfaction obtained from consuming a good or service.
• Total Utility (TU): The total satisfaction obtained from consuming all units of a commodity. It is the sum of marginal utilities: TU = MU1 + MU2 + MU3 + ....
• Marginal Utility (MU): The additional satisfaction obtained from consuming one more unit of a commodity: MU = Change in TU / Change in Quantity. When marginal utility is positive, total utility increases; when marginal utility is zero, total utility is maximum; when marginal utility is negative, total utility decreases.
• Law of Diminishing Marginal Utility: As more units of a commodity are consumed, marginal utility generally decreases, assuming other factors remain unchanged.
• Consumer’s Equilibrium: The situation in which a consumer obtains maximum satisfaction from given income and prices and has no desire to change the consumption plan.
• Equilibrium Using One Commodity: Equilibrium occurs when MUx/Px = MUm, where MUm is the marginal utility of money, provided marginal utility is diminishing. In money terms, marginal utility equals the commodity’s price.
• Equilibrium Using Two Commodities: Equilibrium requires MUx/Px = MUy/Py, with the consumer spending the available income.
• Indifference Curve: A curve showing combinations of two goods that provide the same level of satisfaction.
• Indifference Map: A collection of indifference curves representing different levels of consumer satisfaction. Indifference curves are downward sloping, convex to the origin and non-intersecting; higher curves represent higher satisfaction.
• Marginal Rate of Substitution (MRS): The amount of one good a consumer is willing to give up to obtain one additional unit of another while maintaining the same satisfaction: MRSxy = Units of Y sacrificed / Units of X gained.
• Budget Set: All combinations of goods that a consumer can afford with given income and prices.
• Budget Line: All combinations of two goods that can be purchased by spending the entire income: PxX + PyY = M. Its X-intercept is M/Px and its Y-intercept is M/Py.
• Slope of the Budget Line: The slope is -Px/Py; its absolute value, Px/Py, represents the market rate at which one good can be exchanged for another.
• Consumer Equilibrium with Indifference Curves: Equilibrium occurs where the highest attainable indifference curve is tangent to the budget line: MRSxy = Px/Py. The indifference curve must be convex to the origin.
• Demand: The quantity of a good a consumer is willing and able to purchase at a particular price during a particular period.
• Demand Schedule: A table showing different quantities demanded at different prices.
• Demand Curve: A graphical representation of the relationship between price and quantity demanded, usually sloping downward from left to right.
• Law of Demand: Other factors remaining constant, quantity demanded generally rises when price falls and falls when price rises. Income, tastes, prices of related goods, expectations and other relevant factors are assumed constant.
• Substitution Effect: The change in quantity demanded caused by a change in the relative price of a good, encouraging substitution between goods.
• Income Effect: The change in quantity demanded caused by a change in real purchasing power resulting from a price change.
• Normal Good: A good whose demand rises when consumer income rises and falls when income falls.
• Inferior Good: A good whose demand falls when consumer income rises and rises when income falls.
• Substitute Goods: Goods that can be used in place of each other, such as tea and coffee.
• Complementary Goods: Goods used together, such as cars and petrol.
• Movement Along the Demand Curve: A change in quantity demanded caused only by a change in the good’s own price. A movement down the curve is an expansion of demand; a movement up is a contraction of demand.
• Shift in Demand Curve: A change in demand caused by factors other than the good’s own price, including income, tastes, expectations and prices of related goods. An increase shifts the curve to the right; a decrease shifts it to the left.
• Price Elasticity of Demand: The degree to which quantity demanded responds to a change in the good’s price: Ed = Percentage change in quantity demanded / Percentage change in price.
• Total Expenditure Method: If price and total expenditure move in opposite directions, demand is elastic; if expenditure remains unchanged, demand is unitary elastic; if price and expenditure move in the same direction, demand is inelastic.
• Perfectly Inelastic Demand: Quantity demanded does not change when price changes. The demand curve is vertical and Ed = 0.
• Perfectly Elastic Demand: Consumers demand any quantity at one price but none at a higher price. The demand curve is horizontal and Ed is infinite.
• Unitary Elastic Demand: A percentage change in price causes an equal percentage change in quantity demanded: Ed = 1.
• Income Elasticity of Demand: The responsiveness of quantity demanded to a change in income: Ey = Percentage change in quantity demanded / Percentage change in income.
• Cross Elasticity of Demand: The responsiveness of demand for one good to a change in the price of another: Exy = Percentage change in demand for X / Percentage change in price of Y.

Causes and Consequences

• Because income and available goods are limited, a rational consumer must allocate resources to maximise satisfaction.
• As additional units of a commodity are consumed, the Law of Diminishing Marginal Utility generally causes marginal utility to fall. Consequently, total utility rises while marginal utility is positive, reaches a maximum when marginal utility is zero, and declines when marginal utility becomes negative.
• For one commodity, equilibrium follows when MUx/Px = MUm. For two commodities, equilibrium requires MUx/Px = MUy/Py, together with expenditure of the available income. This equalises marginal utility per unit of money across commodities.
• In indifference-curve analysis, equilibrium occurs at the highest attainable indifference curve subject to the budget constraint. At an interior equilibrium, MRSxy = Px/Py. The convexity of the indifference curve reflects diminishing willingness to substitute one good for another.
• The budget constraint is represented by PxX + PyY = M. A rise in income shifts the budget line outward parallel to itself, while a fall in income shifts it inward parallel to itself. A change in the price of one good changes the slope and one intercept.
• A fall in price generally increases quantity demanded and a rise in price generally decreases it, producing the inverse relationship described by the Law of Demand. This relationship operates mainly through the substitution effect and income effect.
• A change in the good’s own price produces movement along the demand curve. A change in income, tastes, expectations or prices of related goods shifts the entire curve.
• For normal goods, a rise in income generally increases demand; for inferior goods, it generally decreases demand. Demand for substitutes, such as tea and coffee, generally rises when the price of the other substitute increases.
• Demand for complementary goods, such as cars and petrol, generally falls when the price of the related complement increases.
• Elasticity measures the strength of the response of quantity demanded. If Ed > 1, demand is elastic; if Ed < 1, it is inelastic; and if Ed = 1, it is unitary elastic.
• For a straight-line demand curve, elasticity is usually greater than one above the midpoint, equal to one at the midpoint and less than one below the midpoint.
• Price elasticity is affected by the availability of substitutes, the nature of the good, the proportion of income spent, the number of uses, the time period and the possibility of postponing consumption.
• Elasticity analysis assists in understanding consumer responses, business pricing decisions and the effects of taxes or policy changes.

What Gets Asked

• Compare consumer equilibrium using one commodity, two commodities and indifference-curve analysis, including MUx/Px = MUm, MUx/Px = MUy/Py and MRSxy = Px/Py.
• Explain the relationship between total utility and marginal utility under the Law of Diminishing Marginal Utility, including the points at which total utility rises, reaches its maximum and declines.
• Distinguish between a movement along the demand curve and a shift in the demand curve, identifying the roles of own price, income, tastes, expectations and prices of related goods.
• Explain the Law of Demand through the substitution effect and income effect, and distinguish normal goods, inferior goods, substitute goods and complementary goods using tea and coffee and cars and petrol.
• Calculate and interpret price, income and cross elasticity using Ed, Ey and Exy, and distinguish elastic, inelastic, unitary, perfectly elastic and perfectly inelastic demand.
• Explain the budget equation PxX + PyY = M, the intercepts M/Px and M/Py, the slope -Px/Py, and the effects of changes in income and prices on the budget line.