Q.What is consumer's equilibrium? Explain the conditions for achieving consumer's equilibrium using the concept of indifference curves and budget lines. Illustrate with a diagram.
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Start your 14-day free trial to unlock the full solution →The consumer is in equilibrium where the budget line is tangent to the highest attainable indifference curve, with MRS = Px/Py and the indifference curve convex to the origin.
Meaning of Consumer's Equilibrium:
Consumer's equilibrium is the situation in which a consumer, spending a given money income on two goods at given prices, obtains the maximum possible total satisfaction and has no tendency to change the combination of goods he is buying.
Tools used:
- Indifference map — a set of indifference curves, each showing combinations of two goods (X and Y) giving the consumer equal satisfaction; a higher curve represents higher satisfaction, and the consumer wants to reach the highest curve possible.
- Budget line (price line) — a line showing all the combinations of the two goods the consumer can buy by spending the whole of his given income at the given prices; its slope equals the price ratio Px/Py. Determination of equilibrium: The consumer wants to reach the highest indifference curve that his budget line allows. Starting from the budget line, he tries to touch the highest possible indifference curve. This is possible only at the point where the budget line is tangent to (just touches) an indifference curve — the point of tangency (say E). At any other point on the budget line, the line would cut an indifference curve, and the consumer could reach a higher curve by rearranging his purchases; so only the tangency point gives maximum satisfaction. 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 of X for Y (MRS), and the slope of the budget line is the price ratio Px/Py. Hence:
MRS of X for Y = Px/Py.
If MRS > Px/Py, the consumer gains by buying more of X (and less of Y); if MRS < Px/Py, he gains by buying more of Y. Equilibrium is reached only when the two are equal.
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Sufficient (second-order) condition: at the point of tangency the indifference curve must be convex to the origin, i.e. the MRS must be diminishing. This ensures that satisfaction is a maximum (and not a minimum) at that point.
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