Q.(OR) Explain the position of consumer's equilibrium with the help of an indifference curve.
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Start your 14-day free trial to unlock the full solution →A consumer is in equilibrium where the budget line touches (is tangent to) the highest possible indifference curve, with MRS = price ratio and the indifference curve convex to the origin.
Consumer's equilibrium means the situation in which a consumer, spending a given money income on two goods at given prices, obtains the maximum possible satisfaction and has no tendency to change the combination purchased.
Indifference-curve analysis uses two tools:
- The indifference map — a set of indifference curves, each showing combinations of two goods (say X and Y) giving the consumer equal satisfaction; higher curves represent higher satisfaction.
- The budget line (price line) — showing all combinations of the two goods the consumer can buy by spending the whole of a given income at given prices; its slope equals the price ratio Px/Py. The consumer wants to reach the highest indifference curve possible within the budget line. Graphically, as we move along the budget line the consumer tries to touch the highest indifference curve. This is possible only at the point where the budget line is tangent to an indifference curve (the point of tangency). At any other point the budget line would cut an indifference curve, and the consumer could reach a higher curve by re-allocating spending. Conditions of consumer's equilibrium:
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Necessary (first-order) condition — At the equilibrium point the slope of the indifference curve must equal the slope of the budget line. The slope of the indifference curve is the Marginal Rate of Substitution (MRS of X for Y), and the slope of the budget line is the price ratio Px/Py. Hence: MRS(xy) = Px/Py.
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Sufficient (second-order) condition — At the point of tangency the indifference curve must be convex to the origin, i.e. MRS must be diminishing. This ensures that the equilibrium is one of maximum (not minimum) satisfaction.
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