Chapter 2 Consumer equilibrium Part A : Cardinal Utility ... · Part B : Ordinal Utility or...

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Chapter – 2 Consumer equilibrium

Part A : Cardinal Utility approach

This chapter is discussed under two parts: Part A : Cardinal Utility approach Part B : Ordinal Utility or Indifference curve approach

Video Lecture Explanation Part A Cardinal Utility approach

Utility refer to satisfaction received from consuming good or service. It can be measured with star rating or cardinal number like 1,2,3,4 etc. Example : 7 Star Hotel or 5 Star Hotel Cardinal & Ordinal concept of utility Cardinal concept : Comparison of utility in terms of units like 2,4,6 etc.. is cardinal concept of utility . Ordinal concept : Comparison of utility in terms of higher or lower level of satisfaction is ordinal concept of utility . Total utility & Marginal utility Total utility : It is total satisfaction(utility) received from consumption of all unit of commodity . Marginal utility : It is additional satisfaction(utility) received from consumption of one more additional unit of commodity .

MUnth = TUn – TUn-1 Relation between Total utility & Marginal utility

Schedule of TU & MU

Quantity(Units) Total utility Marginal utility 0 1 2 3 4 5 6

0 20 36 46 50 50 44

- 20-0 = 20 36-20 = 16 46-36 = 10 50-46 = 4 50-50 = 0 44-50 = -6 44

Video Lecture 1 : Introduction

1. Meaning of Utility

2. Relationship between Total Utility & Marginal Utility

Video Lecture 2 : Consumer equilibrium - Utility Approach

1. Law of Diminishing Marginal Utility

2. Consumer Equilibrium under one commodity case & two commodity case

Video Lecture Explanation Part B IC approach Video Lecture 3 : Indifference curve

1. Difference between cardinal & ordinal utility

2. Meaning of Indifference curve

3. Marginal rate of substitution (MRS)

4. Monotonic Preference

5. Indifference map

6. Properties of IC

7. Budget line & determinant of budget line

8. Consumer Equilibrium Indifference curve Approach

Video Lecture 4 : Important Question & Answers

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Relation between TU & MU a) TU = ∑MU ( TU = Sum total of MU )

TU of a commodity at particular consumption point must be equal to sum total of MU of that consumption point .

b) TU increases as long as MU is positive TU increase with increase in consumption as long as MU is positive .

c) When MU is zero, TU is maximum TU stop rising at this point . This is known as point of satiety .

d) When MU is negative, TU starts diminishing When consumption is increased beyond point of satiety , TU start falling as MU is –ve.

e) Decreasing MU implies that TU is increasing at diminishing(decreasing) rate This shows that MU is the rate of TU .

Law of diminishing marginal utility This law states that MU tends to decline as consumption of commodity increase. Example : When a cup of tea is consumed frequently , then MU tends to decline. Assumption: a) Consumption of commodity must be continuous. b) Standard unit of commodity must be consumed like cup of tea , not spoon of tea Consumer equilibrium Consumer equilibrium refer to maximum satisfaction received by the consumer by spending his income on different goods & does not have desire to change from that level of consumption. Under this concept , we have to determine how much quantity of commodity a consumer should buy for maximum satisfaction & to attain the point of equilibrium(rest). This is discussed with reference to two different situation : a) When only one commodity is consumed b) When two or more commodity are consumed

Consumer equilibrium : One commodity case Suppose the consumer is purchasing goods worth Rs. 3 per unit.. We are given the marginal utility schedule of

the consumer.

Consumer will be at equilibrium when following condition are satisfied:

Condition 1 : MU(Rupees) = Price

Or

MUM = 𝑀𝑈X

𝑃X (Where, MU(Rupees) =

𝑀𝑈X

𝑃X )

MUM = Price (Rupee worth of satisfaction that consumer expect to get from consumption)

Condition 2 : MU fall as consumption increase due to Law of DMU

Conclusion : At 4 unit of consumption , consumer attains the equilibrium stage .

Quantity Price MU(Rupees) MUx(Utils) Remarks

1 3 8 24

MUX > PX , Consumer will

increase consumption 2 3 6 18

3 3 4 12

4 3 3 9 Consumer equilibrium

(MUX = PX)

5 3 0.5 1.5 MUX < PX , Consumer will

decrease consumption



Consumer equilibrium : Two commodity case Suppose the consumer having Rs 88 with him is purchasing two goods X & Y worth Rs. 8 each. We are given

the marginal utility schedule of the consumer.

Quantity MUx(Utils) MUy(Utils)

1 88 40 2 72 36 3 64 24 4 56 20 5 48 16 6 40 12 7 32 8 8 24 4 9 16 0

10 8 0

Consumer will be at equilibrium when following two condition are satisfied :

Condition 1 : The ratio of Marginal Utility to price should be same in case of both the goods.

In other words : 𝑀𝑈X

𝑃X =

𝑀𝑈y

𝑃y

This can be derived using following approach

a) A consumer in case of single commodity (say X) will attain equilibrium when

𝑀𝑈X

𝑃X = MUM

b) A consumer in case of single commodity (say Y) will attain equilibrium when

𝑀𝑈Y

𝑃Y = MUM

Equating a & b , we get 𝑀𝑈X

𝑃X =

𝑀𝑈y

𝑃y = MUM

As MUM assumed to be constant , the above equilibrium condition can be shown as :

𝑀𝑈X

𝑃X =

𝑀𝑈y

𝑃y

MUM = Price (Rupee worth of satisfaction that consumer expect to get which is same for both the good)

Disequilibrium condition & its impact When MUx ≠ MUy , then either MUx > MUy or MUx < MUy When MUx > MUy , it encourage consumer to buy more of X & less of Y. Buying more of X reduces MUx.

Consumer buy more of X till 𝑀𝑈X

𝑃X =

𝑀𝑈y

𝑃y .

When MUx < MUy , it encourage consumer to buy more of Y & less of X. Buying more of Y reduces MUY.

Consumer buy more of Y till 𝑀𝑈X

𝑃X =

𝑀𝑈y

𝑃y .

Note : Above consumer equilibrium is based on Law of equi – marginal utility , which states that consumer should distribute his income in such a manner that marginal utility derived from each good is equal to get maximum satisfaction. Condition 2 : MU falls as consumption increases . MU of consumption must fall as more of commodity are consumed due to Law of DMU



Part B : Ordinal Utility or Indifference curve approach

Indifference set & Indifference curve Indifference set : It is a set of different combination of two goods which offer thhe consumer the same

level of satisfaction.

Different combination of apples & oranges.

Commodity Y 10 7 5 4

Commodity X 1 2 3 4

Utils 50 50 50 50

Indifference curve : It is a graphical presentation of different combination of two

goods which offer the consumer the same level of satisfaction.

Monotonic preference of consumer & downward sloping IC. Monotonic preference of consumer says higher consumption of commodity will give

higher level of satisfaction.

But if consumer wants to maintain same level of satisfaction (an essential characteristic of IC) Then,

for such condition consumption of goods X will increase & of goods Y should be decrease

accordingly.

Marginal rate of substitution(MRS) It shows the amount of Good Y that the consumer is willing to give up for one more unit of Good X.

MRS = 𝑆𝑎𝑐𝑟𝑖𝑓𝑦𝑐𝑒 𝑜𝑓 𝐺𝑜𝑜𝑑 𝑌

𝐺𝑎𝑖𝑛 𝑜𝑓 𝐺𝑜𝑜𝑑 𝑋 =

Δ 𝑌

Δ 𝑋

Observation :

1) Slope of IC = MRS 2) IC is convex to the origin because the slope of IC = or MRS tends to decline as we move along the curve , left to right.

MRS (A-B) = 3

1 = 3

MRS (B-G) = 2

1 = 2

Indifference map A set of ICs drawn in a graph is called Indifference map. It is based on assumption of monotonic preference of the consumer that higher

consumption of commodity will give higher level of satisfaction.

From the figure it can be observed . a) Higher IC show higher level of satisfaction b) IC do not intersect each other Properties/Characteristics of ICs a) IC slopes downward from left to right.

It shows that consumer consume more of one good ,he must consume less of other good. b) Slope of IC indicate MRS. IC is convex to the origin

Slope of IC tend to diminish as we move down the curve because of which IC is convex to the

origin. c) IC do not cross or intersect each other.

As two IC cannot represent same level of satisfaction , hence they cannot intersect each other . d) When two commodities are consumed ,IC never touches X axis nor Y axis.



e) In an indifference map ,higher IC indicate higher level of satisfaction . Higher IC represent more consumption of goods , which means more utility because of

monotonic preference .

Consumer’s Budget (Budget set & Budget line)

Budget set

It is attainable combination of two goods (Good1 & Good2) which a consumer can buy according to his

budget & price of goods.

Budget line It is a line showing different possible combination of two goods (Good1 & Good2) which a

consumer can buy according to his budget & price of goods.

Suppose , a consumer having budget of Rs 60 to be spent on Good 1 (Rs2) & Good 2 (Rs1)

Following table show set of consumption possibilities according to his income

Unit of Good 1(Rs 2) 0 10 20 30

Unit of Good 2(Rs 1) 60 40 20 0

Line AB is called price line ,as it shows the price of Good1 & Good2. Characteristic of Budget line: a) Budget line is a line that separates feasible combination from non feasible combination. b) A consumer cannot go beyond this budget line . A consumer can only afford to buy only feasible

combination Consumer equilibrium using Indifference Curve Analysis Consumer equilibrium refer to maximum satisfaction received by the consumer by spending his

income on different goods & & does not have desire to change from that level of consumption.

In terms of IC , the consumer will attain the point of equilibrium when following two condition are

satisfied :

a) Slope of IC is equal to slope of budget line

The above condition can be expressed as , MRSXY = PX/PY MRSXY = Slope of IC . It is determined by preference of the consumer.

PX/PY = Slope of Budget Line. It is determined by price of Good X & Good Y.

In the given diagram , MM =Budget Line

IC1 , IC2 , IC3 = Set of IC P is the equilibrium point at which Budget line MM intersect the higher IC2 ,

which is within the consumer budget & cannot move to IC3 , as his income does

not permit.

Consumer will not be in equilibrium at point A & B because they belong to lower IC.

If MRSXY ≠ PX/PY , then either MRRSXY > PX/PY or MRSXY < PX/PY a. If MRSXY > PX/PY, indicate that , for one additional consumption of X , consumer is willing to

sacrifice more unit of Y as compared to what is required in the market . Consequently , consumer start consuming more of X in place of Y , due to which convexity of IC ensure that consumer move downward to right along his IC , MRSXY tends to fall till MRSXY = PX/PY

b. If MRSXY < PX/PY, indicate that , for one additional consumption of X , consumer is willing to

sacrifice less unit of Y as compared to what is required in the market . Consequently , consumer start consuming more of Y in place of X , due to which convexity of IC ensure that consumer move upward to left along his IC , MRSXY tends to rise till MRSXY = PX/PY



b) IC is convex to the origin at the point of equilibrium (where MRS = PX/PY )

It indicate that MRS is declining as we move along the curve from left to right due to Law of Diminishing Marginal Utility. At point P IC2 is convex to origin.

Synonyms

Cardinal Utility Approach Marshall’s Utility Analysis

Marginal Utility Analysis

Law of Diminishing Marginal Utility Gossen’s First Law of Consumption

Fundamental Law of Satisfaction

Fundamental Psychological Law Point of Satiety Point of Maximum Satisfaction Law of Equi-marginal Utility Law of Substitution

Law of Maximum Satisfaction

Gossen’s Second Law Ordinal Utility Approach Indifference Curve Analysis

Hicksian Analysis Budget Line Price Line Price Ratio Marginal Rate of Exchange

IMPORTANT QUESTIONS (Video Explained) 1 Differentiate between Cardinal Utility & Ordinal Utility Sol

2 Explain the relationship between total utility and marginal utility with the help of schedule and diagram.

Or How does total utility change with the change in marginal utility of a commodity? Explain. Sol Refer Notes 3 Explain Law of diminishing marginal utility Sol This law states that MU tends to decline as consumption of commodity increase. Example : When a cup of tea is consumed frequently , then MU tends to decline. Assumption: a) Consumption of commodity must be continuous. b) Standard unit of commodity must be consumed like cup of tea , not spoon of tea 3 Does law of diminishing marginal utility apply in the field of education? Or Define Exception of law of diminishing marginal utility with help of example Sol No, according to law of diminishing marginal utility as we keep on increasing the consumption of a commodity its marginal utility keeps on diminishing. But in case of education, every effort to increase its usage increase utility derived from it, rather than decreasing it. 5 Define Consumer equilibrium ? Sol Refer Notes 6 When is a consumer said to be rational? Sample Paper 2017

Basis Cardinal Utility Ordinal Utility

Meaning Approach Analysis

Comparison of utility in terms of units or numerically Quantitative Marginal Utility Analysis

Comparison of utility in terms of higher or Qualitative Indifference Curve Analysis



A consumer is said to be ‘rational’ when he aims at maximizing his utility from the consumption of the given commodity, within his income . 7 How does a consumer reach equilibrium position when he is buying only one commodity? Explain with the help of marginal utility schedule.

Or How may units of a commodity should a consumer buy to get a maximum utility? Explain with the help of a numerical example. Sol Refer Notes 8 Following is utility schedule of a person :

Units of X 1 2 3 4 5

MU in utils 50 40 30 20 10

Suppose that commodity is sold for Rs 4 & marginal utility of one rupee is 5 utils .How many units of commodity will person purchase to maximise his satisfaction. Sol 4 units 9 An ice-cream seller sells ice-creams for Rs 40 each. Rahul, who loves ice-cream has already eaten 4. His marginal utility from eating 4 ice-creams is 120. Suppose that the marginal utility of one rupee is 4 utils . Should he eat more ice-cream or should he stop? Sol Reduce his consumption Refer Video Explanation 10 Explain the equilibrium condition of a consumer in case of two commodities with the help of utility analysis. Or How does a consumer reach equilibrium in case of two commodities under the cardinal utility theory? Sol Consumer equilibrium is situation of maximum satisfaction of consumer by spending his income on different goods & service & does not have desire to change from that level of consumption.

Sol Consumer will be at equilibrium when following two condition are satisfied : Condition 1 : The ratio of Marginal Utility to price should be same in case of both the goods.

In other words : 𝑀𝑈X

𝑃X =

𝑀𝑈y

𝑃y

This can be derived using following approach

a) A consumer in case of single commodity (say X) will attain equilibrium when

𝑀𝑈X

𝑃X = MUM

b) A consumer in case of single commodity (say Y) will attain equilibrium when

𝑀𝑈Y

𝑃Y = MUM

Equating a & b , we get 𝑀𝑈X

𝑃X =

𝑀𝑈y

𝑃y = MUM

As MUM assumed to be constant . the above equilibrium condition can be shown as :

𝑀𝑈X

𝑃X =

𝑀𝑈y

𝑃y

MUM = Price (Rupee worth of satisfaction that consumer expect to get which is same for both the good)

Disequilibrium condition & its impact When MUx ≠ MUy , then either MUx > MUy or MUx < MUy When MUx > MUy , it encourage consumer to buy more of X & less of Y. Buying more of X reduces MUx.

Consumer buy more of X till 𝑀𝑈X

𝑃X =

𝑀𝑈y

𝑃y .

When MUx < MUy , it encourage consumer to buy more of Y & less of X. Buying more of Y reduces MUY.



Consumer buy more of Y till 𝑀𝑈X

𝑃X =

𝑀𝑈y

𝑃y .

Note : Above consumer equilibrium is based on Law of equi – marginal utility , which states that consumer should distribute his income in such a manner that marginal utility derived from each good is equal to get maximum satisfaction. Condition 2 : MU falls as consumption increases . MU of consumption must fall as more of commodity are consumed due to Law of Diminishing Marginal Utility.

Additional condition : Consumer must spent his entire income on purchase of both the good.

Schedule Explanation

Suppose the consumer having Rs 88 with him is purchasing two goods X & Y worth Rs. 8 each. We are given

the marginal utility schedule of the consumer.

Quantity MUx(Utils) MUy(Utils)

1 88 40

2 72 36

3 64 24

4 56 20

5 48 16

6 40 12

7 32 8

8 24 4

9 16 0

10 8 0

Conclusion : At 8 unit of X & 3 unit of Y consumption , consumer attains the equilibrium stage

X(8×8) + Y(3×8) = X (64) + Y (24) = 88 , where ratio of Marginal Utility to price should be same in case of both

the goods.

11 A consumer, Mr. Aman is in state of equilibrium consuming two goods X and Y, with given

prices Px and Py. Explain what will happen if 𝑀𝑈X

𝑃X is greater than

𝑀𝑈y

𝑃y . Sample Paper 2017

Sol If 𝑀𝑈X

𝑃X >

𝑀𝑈y

𝑃y, then it means that satisfaction of Mr. Aman, derived from spending a rupee on Good X is

greater than the satisfaction derived from spending a rupee on Good Y. Mr. Aman, will reallocate his income to buy more of X & less of Y . Buying more of X reduces MUx. Consumer

buy more of X till 𝑀𝑈X

𝑃X =

𝑀𝑈y

𝑃y .

12 State the law of equi-marginal utility. Sol Law of equi – marginal utility states that consumer should distribute his income between the goods in such a manner that marginal utility derived from last rupee spend on each good is equal to get maximum satisfaction.

13 Define Indifference curve along with its properties. Sol Refer Notes 14 Define Indifference map . Sol Refer Notes 15 Define MRS ? Sol Refer Notes

16 Identify which of the following is not true for the Indifference Curves. Give valid reasons for choice of your answer: Sample Paper 2017 a. Lower indifference curve represents lower level of satisfaction.



b. Two regular convex to origin indifference curves can intersect each other. c. Indifference curve must be convex to origin at the point of tangency with the budget line at the consumer’s equilibrium. d. Indifference curves are drawn under the ordinal approach to consumer equilibrium. Sol (B) is incorrect. Indifference Curves have a property that two ICs cannot intersect because each IC have distinct satisfaction zone & cannot intersect with other . Diagramatic Explanation Suppose, there are any two ICs intersecting each other. As per the figure A =C ( on IC1) D= E (on IC2) But if we see at intersection point B, this shows A=C=B & D=C=B, which is not possible, as they are violating the basic definition of the Indifference Curves. 17 If Marginal Rate of Substitution is constant throughout, the Indifferent curve will be: (choose the correct alternative) (a)Parallel to the x-axis (b) Downward sloping concave (c)Downward sloping convex (d)Downward sloping straight line Sol (d) Downward sloping straight line

18 A consumers consumes only two goods. If price of one of the goods falls the indifference curve (a)Shifts upwards (b)Shift Downwards (c)Can shift both upwards or downwards (d)Dose not shift Ans. (d) Dose not shift

19 What are monotonic preferences? Explain why an indifferent curve to the right shows higher utility level? Sol Monotonic preference of consumer says higher consumption of commodity will give higher level of

satisfaction. Indifference curve to the right shows higher utility level due to higher consumption of both the Goods X & Y. 20 ‘Higher indifference curve represents higher level of satisfaction to the consumer’. Explain the statement, also state the underlying assumption related to this property of indifference curve. Sample Paper 2016 Sol It mean any combination that lie on a higher indifference curve i.e. away from origin represents higher level of satisfaction. The underlying assumption here is the assumption of monotonic preference which says higher consumption of commodity will give higher level of satisfaction. 21 What is a budget line? Explain why is it a straight line? Sol It a straight line because ratio of sacrifice of Good Y for gain of Good X remain constant at all level due to fix price. 22 Give equation of Budget set. Sol PX

x X + P Y x Y ≤ M (Income of consumer) 23 What happens to budget set if both the price as well the income double? Sol Budget set will not change as the doubling of income is offset the doubling of price of both the goods. So the budget set will remain the same as before. 24 How does the budget line change if the price of good 2 decreases by rupee but the price of good 1 and the consumer’s income remain unchanged? Sol If the price of good 2 decreases by a rupee but the price of good 1 and consumer’s income remain unchanged, this shifts the Y axis of the budget line along the Y axis upwards. When the price of good 2 decrease, the budget line change from AB to A1B.

25 A consumer wants to consume two goods. The prices of the two goods are 4 and 5 respectively . The consumer’s income is 20. (a) Write down the equation of the budget line. (b) How much of good 1 can the consumer consume of she spend her entire income on that good?



(c) How much of good 2 can she consume if she spends her entire income on that good? (d) What is the slope of the budget line? Sol The equation of the budget line is:

(a) PX. x X+ P Y. x Y = M, Where Px and Py are the respective prices of the two goods X and Y.

4X x 5 Y = 20

(b) If the given consumer spends her entire income (Rs 20) on the good 1 , whose price is 4 per unit, it means

that she can buy 5 units i.e. 20

5 = 4 units of goods1.

(c) If she spends her entire income on the good 2 , whose price is Rs 5 per unit, it means that she can buy 4

units i.e, 20

5 = 4 units of good 2.

(d) The slope of the budget line = Δ 𝑌

Δ 𝑋

- 𝑃y

𝑃x = -

4

5

26 A consumer has total money income of 500 to be spent on two goods X and Y with prices of 50 and 10 per unit respectively. On the basis of the given information, answer the following questions: a. Give the equation of the budget line for the consumer. b. What is the value of slope of the budget line? c. How many units can the consumer buy if he is to spend all his money income on good X? d. How does the budget line change if there is a 50% fall in price of good Y? Sol Refer above question d) If Py falls the consumer will be able to buy more of good Y under same income pushing Budget Line rotates outwards , keeping the X-intercept constant , and the equation will be 50x +5y = 500. 27 A consumer consumes only two goods. For the consumer to be in equilibrium why must marginal rate of substitution between the two good must be equal to the ratio of prices of these two goods? Is it enough to ensure equilibrium?

Or What are the condition of consumer’s equilibrium under indifferent curve approach? What change will take place if the condition are not fulfilled to reach equilibrium? Sol Consumer equilibrium is situation of maximum satisfaction of consumer by spending his income on different goods & service & does not have desire to change from that level of consumption. In terms of IC , the consumer will attain the point of equilibrium when following two condition are

satisfied :

b) Slope of IC is equal to slope of budget line

The above condition can be expressed as , MRSXY = PX/PY

MRSXY = Slope of IC . It is determined by preference of the consumer.

PX/PY = Slope of Budget Line. It is determined by price of Good X & Good Y.

In the given diagram , MM =Budget Line

IC1 , IC2 , IC3 = Set of IC P is the equilibrium point at which Budget line MM intersect the higher IC2 , which is

within the consumer budget & cannot move to IC3 , as his income does not permit.

Consumer will not be in equilibrium at point A & B because they belong to lower IC.

If MRSXY ≠ PX/PY , then either MRRSXY > PX/PY or MRSXY < PX/PY b. If MRSXY > PX/PY, indicate that , for one additional consumption of X , consumer is willing to




c. If MRSXY < PX/PY, indicate that , for one additional consumption of X , consumer is willing to

sacrifice less unit of Y as compared to what is required in the market . Consequently , consumer start consuming more of Y in place of X , due to which convexity of IC ensure that consumer move upward to left along his IC , MRSXY tends to rise till MRSXY = PX/PY

b) IC is convex to the origin at the point of equilibrium (where MRS = PX/PY )

It indicate that MRS is declining as we move along the curve from left to right due to Law of Diminishing Marginal Utility . At point P IC2 is convex to origin.

28 A consumer consumes only two goods, X and Y. At a consumption level of these two goods, he finds that the marginal rate of substitution is higher than the ratio of the prices . Explain the reaction of the consumer.

Or Explain the concept of marginal rate of substitution. Explain the reaction of the consumer when marginal rate substation is higher than the ratio of price. MRSXY > PX/PY.

Sol Marginal rate of substitution(MRS) : It shows the amount of Good Y that the consumer is willing to give up

for one more unit of Good X.

MRS = 𝑆𝑎𝑐𝑟𝑖𝑓𝑦𝑐𝑒 𝑜𝑓 𝐺𝑜𝑜𝑑 𝑌

𝐺𝑎𝑖𝑛 𝑜𝑓 𝐺𝑜𝑜𝑑 𝑋 =

Δ 𝑌

Δ 𝑋

When MRSXY > PX/PY , indicate that for one additional consumption of X , consumer is willing to


29 A consumer consumes only two goods X and Y priced at 3 per unit, If the consumer chooser a combination of these goods with marginal rate of substation equal to 3, is the consumer in equilibrium? Give reasons. What will a rational consumer do in this situation? Explain. Sol Given that PX = 3 , PY = 3 and Marginal Rate of substitution = 3. A consumer is said to be in equilibrium when MRSXY = PX/PY. By substituting the value, we find that 3 > 3/3 , i.e. MRS > PX/PY in the given case, thus the consumer is not in equilibrium because when MRS > PX/PY , It indicate that for one additional consumption of X , consumer is willing to sacrifice more unit of Y

as compared to what is required in the market . Consequently , consumer start consuming more of X in place of Y , due to which convexity of IC ensure that consumer move downward to right along his IC , MRSXY tends to fall till MRSXY = PX/PY

APPLICATION QUESTION

1. The government offers old-age pension to the senior citizens. An average senior citizen finds an

increase in his money income. How would it impact his equilibrium in terms of IC analysis ?

Sol As a result of increase in money income of an average senior citizen, his budget line would shift to the right. He would now strike equilibrium at a higher IC, getting higher level of satisfaction.

2. Consumer’s equilibrium in struck when PX = MUX (in terms of money). The government fixes a

ceiling on the price of commodity-X, so that the ceiling price is lower than the

equilibrium price. How would it impact the equilibrium of the consumer ?

Sol Owing to ceiling, price is lowered from P1 to P2. Equilibrium shifts from Q1 to Q2. Consumption of commodity increases from OL1 to OL2. Satisfaction level rises, even when consumer’s income is constant.

3. Price of diesel has substantially fallen in the domestic market, owing to a fall

in the price of crude oil in the international market. How would you reflect his

change in terms of budget line of the consumer who spends his given income

on goods X and Y of which X is a diesel.



Sol Budget line rotate rightward as shown in diagram

4. Owing to discriminatory tax policy of the government, the price of Good-X has fallen more than the price of

Good-Y in the Indian markets. How would it impact equilibrium of the consumer who spends his given income

across goods X and Y ? Use utility analysis.

Sol Consumer will be at equilibrium when 𝑀𝑈X

𝑃X =

𝑀𝑈y

𝑃y

PX falls more than PY. So that, 𝑀𝑈X

𝑃X >

𝑀𝑈y

𝑃y

This would induce the consumer to shift some expenditure from Good-Y to Good-X. When the consumption of Good-X increases, MUX would fall. On the other hand, when the consumption of Good-Y

decreases, MUY would rise. The switch-over from Y to X would continue till 𝑀𝑈X

𝑃X =

𝑀𝑈y

𝑃y

5. Owing to influx of FDI, entrepreneurs in the manufacturing sector in India find that the elasticity for their

product has tended to rise. How would you reflect this change in terms of demand curve for an individual firm

in the manufacturing sector in India ?

Sol Firm’s demand curve (AR curve) would become more elastic due to more competetion .

6 Imagine a situation when cash subsidy on domestic LPG is totally withdrawn. Explain its

impact on the welfare level of an average BPL family. Use IC diagram.

Sol When cash subsidy on LPG is withdrawn, disposable income of the BPL family is reduced. In terms of Indifference Curve Analysis, this would mean that the budget line of the average BPL family shifts to the left. Other things remaining constant, it would lead to a cut in its welfare level. This is illustrated through diagram Initially the BPL family is in equilibrium at point E, on IC1. It consumes OL1 of Good-X and OS1 of Good-Y. After cash subsidy is withdrawn, budget line shifts downward, from ab to a1b1. New equilibrium is struck at point E*, on IC2. Being on a lower IC, welfare level of the BPL family is also lowered. Now it consumes OL2 of Good-X and OS2 of Good-Y.


Chapter 2 Consumer equilibrium Part A : Cardinal Utility ... · Part B : Ordinal Utility or...

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