NSDeterminants of Price Elasticity of Supply

Marginal Cost if the cost of producing one more unit keeps rising as output rises or Marginal Costs rises rapidly with an increase in output, then the rate of output production will be limited. Over time price elasticity of supply tends to become more elastic, which means that producers would increase the quantity supplied by a larger percentage than an increase in price. The larger the number of firms, the more likely supply is elastic. If factors of production are mobile, then price elasticity of supply tends to be more elastic. If firms have spare capacity, the price elasticity of supply is elastic. They are able to produce more, and quickly with a change in price.

The main factors which determine the degree of price elasticity of supply (Determinants of price elasticity of supply and demand) are as under:

(1) Time period. Time is the most significant factor which affects the elasticity of supply. If the price of a commodity rises and the producers, have enough time to make adjustment in the level of output, the elasticity of supply will be more elastic. If the time period is short and the supply cannot be expanded after a price increase, the supply is relatively inelastic.

(2) Ability to store output. The goods which can be safety stored have relatively elastic supply over the goods which are perishable and do not have storage facilities.

(3)  Factor mobility. If the factors of production can be easily moved from one use to another, it will affect elasticity of supply. The higher the mobility of factors, the greater is the elasticity of supply of the good and vice versa.(4) Changes in marginal cost of production. If with the expansion of output, marginal cost increases and marginal return declines, the price elasticity of supply will be less elastic to that extent.

(5)  Excess supply. When there is excess capacity and the producer can increase output easily to take advantage of the rising prices, the supply is more elastic. In case the production is already upto the maximum from the existing resources, the rising prices will not affect supply in the short period. The supply will be more inelastic.

(6)  Availability of, infrastructure facilities. If infrastructure facilities are available for expanding output-of a particular good in response to the rise in prices, the elasticity of supply will be relatively more elastic.

(7)  Agricultural or industrial products. In agriculture, time is required to increase output in response to rise in prices of goods. The supply of agricultural goods is fairly inelastic. As regards the supply of manufactured consumer goods, it is comparatively easy- to increase production in a short period. Therefore, the supply of consumer goods is fairly more elastic. In case of supply of aero planes or any other heavy machinery, the supply Is relatively inelastic as it takes time to manufacture heavy machinery.

Theory of Consumer BehaviourThere are two main approaches to the theory of consumer behaviour to demand in Economics. The first approach is the Marginal Utility or Cardinals’ Approach. The second is the Ordinalist Approach.

1. CARDINAL UTILITY ANALYSISHuman wants are unlimited and they are of different intensity. The means at the disposal of a man are not only scarce but they have alternative uses. As a result of scarcity of resources, the consumer cannot satisfy all his wants. He has to choose as to which want is to be satisfied first and which afterward if the resources permit. The consumer is confronted in making a choice. For example, a man’ is thirsty. He goes to the market and satisfies his thirst by purchasing coca’-cola instead of tea. We are here to examine the economic forces which. Make him purchase a particular commodity. The answer is simple. The consumer buys a commodity because it gives him satisfaction. In technical term, a consumer purchases a commodity because it has utility” for him. We now examine the tools which are used in the analysis of. Consumer behavior.

2. CONCEPT OF UTILITYJevons (1835-1882) was the first economist who introduced the concept of utility in economics. According to him ‘utility’ is the basis on which the demand of an individual for a commodity depends ‘Utility’ is defined as the power of a commodity or service to satisfy human want. Utility thus is the satisfaction which is derived by the consumer by consuming the goods. For example, cloth has a utility for us because we can wear it. Pen has a utility for a person who can write with it. The utility is subjective in .nature. It differs from person to person. The utility of a bottle of wine is zero for a person who is non drinker while it has a very high utility for a drinker Here it may be noted that the term ‘utility’ may not be confused with pleasure or unfulness which a commodity gives to an individual. Utility is a subjective satisfaction which consumer gets from .consuming any good or service. For example, Poison is injurious to health but it gives subjective satisfaction to a person who wishes to die. We can say that utility is value neutral.

QUESTIONS1. What do you mean by the concept of utility? Show that the total

utility is maximum when marginal utility is zero.3. Enunciate the law of diminishing marginal utility. Describe its limitations and importance.4. Define the law of diminishing m

2. Explain in brief the theory of consumer behaviour.3. arginal utility and explain carefully the relation it bears to principle

of taxation.5. Discuss the relationship between the lavi/ of diminishing utility and the law of demand.6.    “The application of the principle of substitution extends over almost every field of economic equally”. Marshall Explain.7.  Explain the law of equi-marginal utility. What is its practical importance?8. Explain and discuss the law of substitution with the help of a. diagram.9. Show the consumers equilibrium in terms of law of equi-marginal utility.10. Explain the equilibrium of the consumer in terms of the utility

analysis.11. Discuss the relationship between the law of diminishing utility and the law of demand.A. SHORT ANSWER QUESTIONS1. Is utility subjective in nature?2. Which laws have been developed from the marginal utility analysis?3. What are the main assumptions on which the cardinal utility analysis is based?4. How will you differentiate between total utility and marginal utility?5.    How the concept of marginal utility helps in explaining the Paradox of Value?6. What is meant by consumer’s equilibrium?7. State the consumers equilibrium equation for utility maximization.8. Why an individual purchases more of a commodity per unit of time when its price falls. Cardinal utility approach assumes which of the following:

(i) Mu of money is variable

(ii) Mu of money remains constant

(iii) Mu of money is greater than the utility of good. ANSWERS:1. Yes. The utility is a measurable and quantifiable entity. It is purely subjective in nature. If differs from person to person and even with the same person at differenttimes.2. The founders of marginal utility analysis have developed two laws from it namely (1) The law of diminishing marginal utility and (ii) The law of equi marginal utility.3. The main premises on which the cardinal utility rests are:(I) Consumer is rational

(ii) Utility is cardinally measurable (iii) Marginal utility of money remains constant. (iv) The goods posse’s independent utilities (v) It is based upon introspection.4. Total utility is the total satisfaction obtained from all the units of a particular product consumed over a period of time.Marginal utility is the additional utility derived from the consumption of one more unit of the product.

5. The marginal utility analysis has helped in explaining the Paradox of Value. The question as to why some commodities which are very essential to life cost much less than other which could be easily foregone. For instance-, water is very essential for life but it has a very low price. Diamonds, on the other hand, are not essential but they have a very high price. This Paradox of Value is explained with the help of marginal utility analysis. According to the modern economist, the total utility derived from a commodity does not determine its price. If is the marginal utility which is important in the determination of price. As water is generally available in large quantities, so its marginal utility is very low or zero. Diamonds, on the other hand, are scarce and their relative marginal utility is quite high. That is why the prices of diamonds are high.6. A consumer is said ‘to be in equilibrium or he maximizes total utility from spending his income when the marginal utility of the last rupee spent on each commodity is the sarn e.MUx MUy   7. The consumer is in equilibrium when the following equation holds good px-                        -rY8. A consumer purchases more units of the commodity only at lower prices when each “- additional unit of the commodity gives the individual less extra or marginal utility.9. The Cardinal Utility approach assumes that the MU of money remains constant.

Theory of Ordinal Utility/Indifference Curve Analysis: Definition and Explanation: The indifference curve indicates the various combinations of two goods which yield equal satisfaction to the consumer. By definition: "An indifference curve shows all the various combinations of two goods that give an equal amount of satisfaction to a consumer". The indifference curve analysis approach was first introduced by Slustsky, a Russian Economist in 1915. Later it was developed by J.R. Hicks and R.G.D. Allen in the year 1928. These economist are the of view that it is wrong to base the theory of consumption on two assumptions: 

(i) That there is only one commodity which a person will buy at one time. (ii) The utility can be measured. Their point of view is that utility is purely subjective and is immeasurable. Moreover an individual is interested in a combination of related goods and in the purchase of one commodity at one time. So they base the theory of consumption on the scale of preference and the ordinal ranks or orders his preferences.  Assumptions:  The ordinal utility theory or the indifference curve analysis is based on four main assumptions. (i) Rational behavior of the consumer: It is assumed that individuals are rational in making decisions from their expenditures on consumer goods. (ii) Utility is ordinal: Utility cannot be measured cardinally. It can be, however, expressed ordinally. In other words, the consumer can rank the basket of goods according to the satisfaction or utility of each basket. (iii) Diminishing marginal rate of substitution: In the indifference curve analysis, the principle of diminishing marginal rate of substitution is assumed. (iv) Consistency in choice: The consumer, it is assumed, is consistent in his behavior during a period of time. For insistence, if the consumer prefers combinations of A of good to the combinations B of goods, he then remains consistent in his choice. His preference, during another period of time does not change. Symbolically, it can be expressed as: 

If A > B, then B > A (iv) Consumer’s preference not self contradictory: The consumer’s preferences are not self contradictory. It means that if combinations A is preferred over combination B is preferred over C, then combination A is preferred over combination A is preferred over C. Symbolically it can be expressed: 

If A > B and B > C, then A > C (v) Goods consumed are substitutable: The goods consumed by the consumer are substitutable. The utility can be maintained at the same level by consuming more of some goods and less of the other. There are many combinations of the two commodities which are equally preferred by a consumer and he is indifferent as to which of the two he receives.  Example: For example, a person has a limited amount of income which he wishes to spend on two commodities, rice and wheat. Let us suppose that the following commodities are equally valued by him: 

Various Combinations: a)      16 Kilograms of Rice          Plus          2 Kilograms of Wheatb)      12 Kilograms of Rice          Plus          5 Kilograms of Wheatc)      11 Kilograms of Rice          Plus          7 Kilograms of Wheatd)      10 Kilograms of Rice          Plus          10 Kilograms of Wheate)      9   Kilograms of Rice          Plus          15 Kilograms of Wheat It is matter of indifference for the consumer as to which combination he buys. He may buy 16 kilograms of rice and 2 kilograms of wheat or 9 kilograms of rice and 15 kilograms of wheat. All these combinations are equally preferred by him. An indifference curve thus is composed of a set of consumption alternatives each of which yields the same total amount of satisfaction. These combinations can also be shown by an indifference curve. Figure/Diagram of Indifference Curve: The consumer’s preferences can be shown in a diagram with an indifference curve. The indifference showing nothing about the absolute amounts of satisfaction obtained. It merely indicates a set of consumption bundles that the consumer views as being equally satisfactory. 

 In fig. 3.1 we measure the quantity of wheat along X-axis (in kilograms) and along Y-axis, the quantity of rice (in kilograms). IC is an indifference curve. It is shown in the diagram that a consumer may buy 12 kilograms of rice and 5 kilograms of wheat or 9 kilograms of rice and 15 kilogram of wheat. Both these combinations are equally

preferred by him and he is indifferent to these two combinations. When the scale of preference of the consumer is graphed, by joining the points a, b, c, d, e, we obtain an Indifference Curve IC. Every point on indifference curve represents a different combination of the two goods and the consumer is indifferent between any two points on the indifference curve. All the combinations are equally desirable to the consumer. The consumer is indifferent as to which combination he receives. The Indifference Curve IC thus is a locus of different combinations of two goods which yield the same level of satisfaction. An Indifference Map: A graph showing a whole set of indifference curves is called an indifference map. An indifference map, in other words, is comprised of a set of indifference curves. Each successive curve further from the original curve indicates a higher level of total satisfaction. 

 In the fig. 3.2 three indifference curves IC1, IC2 and IC3 have been shown. The various combinations of goods of wheat and rice lying on IC1 yield the same level of satisfaction to the consumer. The combinations of goods lying on higher indifference curve IC2 contain more both the goods wheat and rice. The indifference curve IC2 gives more satisfaction to the consumer than IC1. Similarly, the set of combinations of two goods on IC3 yields still higher satisfaction to the consumer than IC2. In short, the further away a particular curve is from the origin, the higher level of satisfaction it represents. It may here be noted that while an indifference curve shows all those combinations of wheat and rice which provide equal satisfaction to the consumer but it does not indicate exactly how much satisfaction is derived by the consumer from these combinations. It is because of the fact that the concept of ordinal utility does not involve the qualitative measurement of utility.

Marginal Rate of Substitution (MRS): Definition and Explanation: The concept of marginal rate substitution (MRS) was introduced by Dr. J.R. Hicks and Prof. R.G.D. Allen to take the place of the concept of d iminishing marginal utility . Allen and Hicks are of the opinion that it is unnecessary to measure the utility of a commodity. The necessity is to study the behavior of the consumer as to how he prefers one commodity to another and maintains the same level of satisfaction.

 

For example, there are two goods X and Y which are not perfect substitute of each other. The consumer is prepared to exchange goods X for Y. How many units of Y should be given for one unit of X to the consumer so that his level of satisfaction remains the same?

 

The rate or ratio at which goods X and Y are to be exchanged is known as the marginal rate of substitution (MRS). In the words of Hicks:

 

“The marginal rate of substitution of X for Y measures the number of units of Y that must be scarified for unit of X gained so as to maintain a constant level of satisfaction”.

 

Marginal rate of substitution (MRS) can also be defined as:

 

“The ratio of exchange between small units of two commodities, which are equally valued or preferred by a consumer”.

 

Formula: 

MRSxy = ∆Y

                                                                                      ∆X

 

It may here be noted that the marginal rate of substitution (MRS) is the personal exchange rate of the consumer in contrast to the market exchange rate.

 

Schedule: 

The concept of MRS can be easily explained with the help of schedule given below:

 

Marginal Rate of Substitution 

Combination Good X Good Y MRS of X for Y 1 1 13 --2 2 9 4 : 13 3 6 3 : 14 4 4 2 : 15 5 3 1 : 1

 

In the table given above, all the five combinations of good X and good Y give the same satisfaction to the consumer. If he chooses first combination, he gets 1 unit of good X and 13 units of good Y.

 

In the second combination, he gets one more unit of good X and is prepared to give 4 units of good Y for it to maintain the same level of satisfaction. The MRS is therefore, 4:1.

 

In the third combination, the consumer is willing to sacrifice only 3 units of good Y for getting another unit of good X. The MRS is 3:1.

 

Likewise, when the consumer moves from 4th to 5th combination, the MRS of good X for good Y falls to one (1:1). This illustrates the diminishing marginal rate of substitution.

 

Diminishing Marginal Rate of Substitution: In the above schedule, we have seen that as the consumer moves from combination first to fifth, the rate of substitution of good X for good Y goes, down. In other words, as the consumer has more and more units of good X, he is prepared to forego less and less of good Y.

 

For instance, in the 2nd combination, the consumer is willing to give 4 units of good Y in exchange for one unit of good X, in the fifth combination only one unit of Y is offered for obtaining one unit of X.

 

This behavior showing falling MRS of good X for good Y and yet to remain at the same level of satisfaction is known as diminishing marginal rate of substitution.

 

Diagram/Figure: 

The concept of marginal rate of substitution (MRS) can also be illustrated with the help of the diagram.

 

 

In the fig. 3.3 above as the consumer moves down from combination 1 to combination 2, the consumer is willing to give up 4 units of good Y (∆Y) to get an additional unit of good X (∆X).

 

When the consumer slides down from combinations 2, 3 and 4, the length of ∆Y becomes smaller and smaller, while the length of ∆X is remain the same. This shows that as the stock of the consumer for good X increases, his stock of good Y decreases.

 

He, therefore, is willing to give less units of Y to obtain an additional unit of good X. In other words, the MRS of good X for good Y falls as the consumer has more of good X and less of good Y. The indifference curve IC slopes downward from left to the right. This means a negative and diminishing rate of substitution of one commodity for the other.

 

Importance of Marginal Rate of Substitution (MRS): (i) Measures utility ordinally: The concept of MRS is superior to that of utility concept because it is more realistic and scientific than the theory of utility. It does not measure the utility of a commodity in isolation without reference to other commodities but takes into consideration the combination of related goods to which a consumer is interested to purchase. (ii) A relative concept: The concept of marginal rate of substitution has the advantage that it is relative and not absolute like the utility concept given by Mars

Properties/Characteristics of Indifference Curve: Definition, Explanation and Diagram: An indifference curve shows combination of goods between which a person is indifferent. The main attributes or properties or characteristics of indifference curves are as follows:

 

(1) Indifference Curves are Negatively Sloped:  

The indifference curves must slope down from left to right. This means that an indifference curve is negatively sloped. It slopes downward because as the consumer increases the consumption of X commodity, he has to give up certain units of Y commodity in order to maintain the same level of satisfaction.

 

 

In fig. 3.4 the two combinations of commodity cooking oil and commodity wheat is shown by the points a and b on the same indifference curve. The consumer is indifferent towards points a and b as they represent equal level of satisfaction.

 

At point (a) on the indifference curve, the consumer is satisfied with OE units of ghee and OD units of wheat. He is equally satisfied with OF units of ghee and OK units of wheat shown by point b on the indifference curve. It is only on the negatively sloped curve that different points representing different combinations of goods X and Y give the same level of satisfaction to make the consumer indifferent.

 

(2) Higher Indifference Curve Represents Higher Level: 

A higher indifference curve that lies above and to the right of another indifference curve represents a higher level of satisfaction and combination on a lower indifference curve yields a lower satisfaction.

 

In other words, we can say that the combination of goods which lies on a higher indifference curve will be preferred by a consumer to the combination which lies on a lower indifference curve.

 

 

In this diagram (3.5) there are three indifference curves, IC1, IC2 and IC3 which represents different levels of satisfaction. The indifference curve IC3 shows greater amount of satisfaction and it contains more of both goods than IC2 and IC1 (IC3 > IC2 > IC1).

 

(3) Indifference Curve are Convex to the Origin:  

This is an important property of indifference curves. They are convex to the origin (bowed inward). This is equivalent to saying that as the consumer substitutes commodity X for commodity Y, the marginal rate of substitution diminishes of X for Y along an indifference curve.

 

 

In this figure (3.6) as the consumer moves from A to B to C to D, the willingness to substitute good X for good Y diminishes. This means that as the amount of good X is increased by equal amounts, that of good Y diminishes by smaller amounts. The marginal rate of substitution of X for Y is the quantity of Y good that the consumer is willing to give up to gain a marginal unit of good X. The slope of IC is negative. It is convex to the origin.

 

(4) Indifference Curve Cannot Intersect Each Other: 

Given the definition of indifference curve and the assumptions behind it, the indifference curves cannot intersect each other. It is because at the point of tangency, the higher curve will give as much as of the two commodities as is given by the lower indifference curve. This is absurd and impossible.

 

 

In fig 3.7, two indifference curves are showing cutting each other at point B. The combinations represented by points B and F given equal satisfaction to the consumer because both lie on the same indifference curve IC2. Similarly the combinations shows by points B and E on indifference curve IC1 give equal satisfaction top the consumer.

 

If combination F is equal to combination B in terms of satisfaction and combination E is equal to combination B in satisfaction. It follows that the combination F will be equivalent to E in terms of satisfaction. This conclusion looks quite funny because combination F on IC2 contains more of good Y (wheat) than combination which gives more satisfaction to the consumer. We, therefore, conclude that indifference curves cannot cut each other.

 

(5) Indifference Curves do not Touch the Horizontal or Vertical Axis: 

One of the basic assumptions of indifference curves is that the consumer purchases combinations of different commodities. He is not supposed to purchase only one commodity. In that case indifference curve will touch one axis. This violates the basic assumption of indifference curves.

 

 

In fig. 3.8, it is shown that the in difference IC touches Y axis  at point C and X axis at point E. At point C, the consumer purchase only OC commodity of rice and no commodity of wheat, similarly at point E, he buys OE quantity of wheat and no amount of rice. Such indifference curves are against our basic assumption. Our basic assumption is that the consumer buys two goods in combination.

Price Line or Budget Line: Definition and Explanation: 

The understanding of the concept of budget line is essential for knowing the theory of consumer’s equilibrium.

 

"A budget line or price line represents the various combinations of two goods which can be purchased with a given money income and assumed prices of goods".

 

For example, a consumer has weekly income of $60. He purchases only two goods, packets of biscuits and packets of coffee. The price of each packet of biscuits is $6  and the price of each packet of coffee is $12. Given the assumed income and the price, of the two goods, the consumer can purchase various combination of goods or market combination of goods weekly.

 

Schedule: 

The various alternative market baskets (combinations of goods) are shown in the table below:

 

Market Basket Packets of Biscuits Per Week Packets of Coffee Per Week

A 10 0

B 8 1

C 6 2

D 4 3

E 2 4

F 0 5

Income $60 Per Week = Packets of Biscuits Costs $6 = Packets of Coffee is Priced $12 Each 

(i) Market basket A in the table above shows that if the whole amounts of $60 is spent on the purchase of biscuits, then the consumer buys 10 packets of biscuits at a price of $6 each and nothing is left to purchase coffee.

 

(ii) Market basket F shows the other extreme. If the consumer spends the entire amount of $60 on the purchase of coffee, a maximum of 5 packets of coffee can be purchased with it at a price of $12 each with nothing left over for the purchase of biscuits.

 

(iii) The intermediate market baskets B to E shows the mixes of packets of biscuits and packets of coffee that the cost a total of $60. For example, in combination of market basket C, the consumer can purchase 6 packets of biscuits and 2 packets of coffee with a total cost of $60.

 

Budget Line: 

The budget line is an important element analysis of consumer behavior. The indifference map shows people’s preferences for the combination of two goods. The actual choices they will make, however, depends on their income. The budget line is drawn as a continuous line. It identifies  the options from which the  consumer can choose the combination of goods.

 

Diagram/Figure: 

 

In the fig. 3.9 the line AF shows the various combinations of goods the consumer can purchase. This line is called the budget line.

 

It shows 6 possible combinations of packets of biscuits and packets if coffee which a consumer can purchase weekly. These combinations are indicated by points A, B, C, D, E and. Point A indicates that 10 packet of biscuits can be purchased if the entire income of $60 is devoted to the purchase of biscuits. Similarly, point F shows the purchase of 5 packets of coffee for the entire income of $60 per week.

 

The budget line AF indicates all the combinations of packets of biscuits and packets of coffee which a consumer can buy given the assumed prices and income. In case, a consumer decides to purchase combination of goods inside the budget line such as G, then it involves  a total outlay that is smaller then the amount of $60 per week. Any point outside the budget line such as H requires an outlay larger than the consumer’s weekly income of $60.

 

The slope of the budget line indicates how many packets of biscuits a purchaser must give up to buy one more packet of coffee. For example, the slope at point B on the budget line is ∆Y / ∆X or two packets of biscuits 1 = packet of coffee. This indicates that a move from B to C involves sacrificing two packets of biscuits to gain an additional one packet of coffee. Since AF budget line is straight, the slope is constant at -2 packets of biscuits per one packet of coffee at all points along the line.

 

Shifts in Budget Line: 

The price line is determined by the income of the consumer and the prices of goods in the market. If there is a change in the income of the consumer or in the prices of goods, the price line shifts in response to a exchange in these two factors.

 

(i) Income changes: When there is change in the income of the consumer, the prices of goods remaining the same, the price line shifts from the original position. It shifts upward or to the right hand side in a parallel position with the rise in income.

 

A fall in the level of income, product prices remaining unchanged, the price line shifts left side from the original position. With a higher income, the consumer can purchase more of both goods than before but the cost of one good in terms of the other remains the same.

 

 

In the fig. 3.10 (a), a change in income is shown when product prices remain unchanged. The rise in income results in a parallel upward shifts in the budget line from L/ M/ to L2M2. The consumer is able to purchase more of both the goods A and B.

 

(ii) Price changes. Now let us consider that there is a change in the price of one good. The income of the consumer and price of other good is held constant. When there is a fall in the price of one good say commodity A, the consumer purchases more of that good than before. A price change causes the budget line to rotate about point L fig. 3.10 (b).

 

 

It becomes flatter and give the new budget line from LM/ to LM2. A flatter budget line means that the relative price of the good A on the horizontal axis is lower. If the greater amount is spent on the purchase of good A, the consumer can buy increased OM2 amount of good A.

Consumer's Equilibrium Through Indifference Curve Analysis: Definition: "The term consumer’s equilibrium refers to the amount of goods and services which the consumer may buy in the market given his income and given prices of goods in the market".

 

The aim of the consumer is to get maximum satisfaction from his money income. Given the price line or budget line and the indifference map:

 

"A consumer is said to be in equilibrium at a point where the price line is touching the highest attainable indifference curve from below".

 

Conditions: 

Thus the consumer’s equilibrium under the indifference curve theory must meet the following two conditions:

 

First: A given price line should be tangent to an indifference curve or marginal rate of satisfaction of good X for good Y (MRSxy) must be equal to the price ratio of the two goods. i.e.

 

MRSxy = Px / Py

 

Second: The second order condition is that indifference curve must be convex to the origin at the point of tangency.

 

Assumptions: The following assumptions are made to determine the consumer’s equilibrium position.

 

(i) Rationality: The consumer is rational. He wants to obtain maximum satisfaction given his income and prices.

 

(ii) Utility is ordinal: It is assumed that the consumer can rank his preference according to the satisfaction of each combination of goods.

 

(iii) Consistency of choice: It is also assumed that the consumer is consistent in the choice of goods.

 

(iv) Perfect competition: There is perfect competition in the market from where the consumer is purchasing the goods.

 

(v) Total utility: The total utility of the consumer depends on the quantities of the good consumed.

 

Explanation:

The consumer’s consumption decision is explained by combining the budget line and the indifference map. The consumer’s equilibrium position is only at a point where the price line is tangent to the highest attainable indifference curve from below.

(1) Budget Line Should be Tangent to the Indifference Curve:

The consumer’s equilibrium in explained by combining the budget line and the indifference map.

Diagram/Figure:

In the diagram 3.11, there are three indifference curves IC1, IC2 and IC3. The price line PT is tangent to the indifference curve IC2 at point C. The consumer gets the maximum satisfaction or is in equilibrium at point C by purchasing OE units of good Y and OH units of good X with the given money income.

The consumer cannot be in equilibrium at any other point on indifference curves. For instance, point R and S lie on lower indifference curve IC1 but yield less satisfaction. As regards point U on indifference curve IC3, the consumer no doubt gets higher satisfaction but that is outside the budget line and hence not achievable to the consumer. The consumer’s

equilibrium position is only at point C where the price line is tangent to the highest attainable indifference curve IC2 from below.

(2) Slope of the Price Line to be Equal to the Slope of Indifference Curve:

The second condition for the consumer to be in equilibrium and get the maximum possible satisfaction is only at a point where the price line is a tangent to the highest possible indifference curve from below. In fig. 3.11, the price line PT is touching the highest possible indifferent curve IC2 at point C. The point C shows the combination of the two commodities which the consumer is maximized when he buys OH units of good X and OE units of good Y.

Geometrically, at tangency point C, the consumer’s substitution ratio is equal to price ratio Px / Py. It implies that at point C, what the consumer is willing to pay i.e., his personal exchange rate between X and Y (MRSxy) is equal to what he actually pays i.e., the market exchange rate. So the equilibrium condition being Px / Py being satisfied at the point C is:

Price of X / Price of Y = MRS of X for Y

The equilibrium conditions given above states that the rate at which the individual is willing to substitute commodity X for commodity Y must equal the ratio at which he can substitute X for Y in the market at a given price.

(3) Indifference Curve Should be Convex to the Origin:

The third condition for the stable consumer equilibrium is that the indifference curve must be convex to the origin at the point of equilibrium. In other words, we can say that the MRS of X for Y must be diminishing at the point of equilibrium. It may be noticed that in fig. 3.11, the indifference curve IC2 is convex to the origin at point C. So at point C, all three conditions for the stable-consumer’s equilibrium are satisfied.

Summing up, the consumer is in equilibrium at point C where the budget line PT is tangent to the indifference IC2. The market basket OH of good X and OE of good Y yields the greatest satisfaction because it is on the highest attainable indifference curve. At point C:

 MRSxy = Px / Py

Application of Indifference Curve Analysis: We now describe in brief as to how indifference curves and budget lines can be used to analysis the effects on consumption due to (a) changes in the income of a consumer (b) changes in the price of a commodity.

 

(1) Changes in Consumer's Equilibrium (Income Effect): Definition and Explanation: 

In the consumer’s equilibrium analysis, it is primarily assumed that the price of the goods X and Y and the income of the consumer remains constant. We now examine as to how the consumer reacts as regards to his purchases of good when his income changes within the indifference curve frameworks. Income is one of the most important factors affecting the purchase of commodities.

 

If the prices of goods, tastes and preferences of the consumer remains constant and there a change in his income, it will directly affect consumer’s demand. This effect on the purchase due to change in income is called the income effect.

 

A rise in consumer’s income will shift the price line or budget line upward to the right and he goes on to higher point of equilibrium. A fall in the income, will shift the price line downward to the left and the consumer attains lower (tangency) points of equilibrium. The shift of the price line is parallel as the prices of the goods are assumed to remain the same. The income effect is explained with the help of following diagram.

 

Diagram/Figure: 

 

In the diagram (3.12) wheat is measured along OX and rise along OY. When the price line or budget line is BB/ , the consumer gets maximum satisfaction or is in equilibrium position at point K where it touches the indifference curve IC1. The consumer buys OS quantity of wheat and ON quantity of rice. We suppose now that the income of the consumer has increased and the price line is now CC1. Which shifts in a parallel fashion to the right.

 

The consumer is in equilibrium at a level at point L which is its equilibrium point. If there is further increase in income: shift of the price line now will be DD1, and the consumer is in equilibrium at point T and will be purchasing OZ quantity of wheat and OE quantity of rice. If these, equilibrium points K, L, T are joined together by a dotted line passing through the origin, we get income consumption curve ICC.

 

This shows that with the rise in income, the consumer generally buys more quantities of the two commodities rice and wheat. The income consumer is now better off at T on indifference curve IC3 as compared to L at a lower indifference curve IC2 . The income effect is positive in case of both the goods rice and wheat as these are normal goods. The income consumption curve ICC which is derived by joining the successive equilibrium positions has a positive slope.

 

Example: 

Income Effect When Wheat is an Inferior Good: 

Sometimes it also happens that with the rise in income, the consumer buys more of one commodity and less of another. For instance, he may buy less of wheat and more of rice as is, illustrated in figures 3.13.

 

 

In diagram 3.13, the income consumption curve bends back on itself. With the rise in income, the consumer buys more of rice and less of wheat. The price effect for rice is positive and for wheat is negative. The good which is purchased less with the increase in income is called inferior good.

 

Income Effect When Rice is an Inferior Good: 

 

In the figure 3.14, it is shown that with the rise in money income, the purchase of wheat has increased from M1 to M4 indicating positive income effect on the purchase of normal good wheat. The income effect on inferior good is negative. The income consumption curve ICC is starts bending towards the horizontal axis which shows that wheat is a normal good and rice is inferior good.

 

(2) Changes in Consumer’s Equilibrium (Price Effect): 

Price Effect on the Consumption of a Normal Good:

 

We now discuss the reaction of the consumer to the changes in the price of a good while his money income, tastes, preferences and prices of other goods remain unchanged. When there is change in the price of a good shown on the two axes of an indifference map, there takes place a change in demand in response to a change in price of a commodity, other things remaining the same, is called price effect.

 

 

For example in fig. 3.15, AB is the initial budget line. It is assumed that the price of wheat has fallen and the price of rice and the income of the consumer remains unchanged. The price line takes a new position AC and the equilibrium point shifts from P to U.

 

The consumer buys now OT quantity of wheat (the amount demanded rises from OE to OT and OZ quantity of rice. With further fall in the price of wheat, the consumer is in equilibrium at point S, where the budget line AD is tangent to a higher indifference curve AC3. He buys now OF quantity of wheat and OR quantity of rice.

 

The rise in amount purchased of wheat (OE to OF) as a result of a fall in its price is called price effect. The price effect on the consumption of a normal good is negative. If we join the equilibrium points PUS, we get price consumption curve (PCC) of the consumer for the commodity wheat.

 

Price Effect When Commodity X is a Giffen Good: 

Giffen good is a particular type of inferior good. When there is a decrease in the quantity demanded of a good with a fall in its price, the good is called Giffen good after the name of Robert Giffen.

 

A British Economist Robert Giffen (1837-1910), observed that sometimes it so happens that a decrease in the price of a particular good causes its quantity demanded to fall. The consumer spends the money he saves (by curtailing the demand) on the purchase of increased quantity of the other good. The decease in the price of Giffen good has an effect similar to an an increase in the income of a buyer. This particular type of behavior of the consumer to decrease demanded of good when its price falls is called Giffen Paradox.

 

The price effect on the consumption of the Giffen good X is now explained with the help of diagram below:

 

 

In fig. 3.16, the consumer is in equilibrium at point E where the budget line AB is tangent to the indifference curve IC1. The consumer purchases OX1 quantity of Giffen good X and OY1 quantity of good Y.

 

When there is a reduction in the price of good X but no change in the price of good Y, the budget line AB/ will showing upward. The consumer is in equilibrium at point E/ where the

budget line AB/ is a tangent to the indifference curve IC2. In the new equilibrium position, the consumer purchases only OX2 units of Giffen good X and OY2 units of good Y.

 

We find that the decrease in the price of Giffen good X, its quantity purchased has fallen from OX1 to OX2 and the quantity demanded of Y commodity goes up from OY1 to OY2. The price effect on the consumption of Giffen good is positive. If is indicated by the backward bending PCC in the case of X as a Giffen good.

 

(3) Consumer’s Equilibrium and the Substitution (Effect of Price Change): 

In the economic literature, there are two slightly different methods for explaining the impact of a price change on the quantity demanded of the two the two goods by the consumer. The first method is attributed to Hicks and Allen and is named as Hicks-Allen Substitution Effect.

 

The second put forward by S. Slutsky, a Russian Economist, is known as Slutsky Substitution Effect.

 

The two concept differ in the way in which real income of the consumer is to be maintained constant when the substitution effect is to be observed. We explain the Hicks-Allen Method of tracing the substitution effect.

 

Hicks-Allen Substitution Effect: 

In the Hicksian method, price changes is accompanied by so much change in money income that the consumer is neither better off nor worse off than before. The money income is changed by an amount which keeps the consumer on the same indifference curve.

 

For instance, the price of good say X falls, and that of good Y remains unchanged. With this fall in the price of good X, then the real income of the consumer would increase. This increase in the real income of the consumer is so withdrawn that he is neither better off nor worse off than above. The amount by which the money income is reduced is called compensating variation in income.

 

Substitution effect thus means the change in its relative price alone, real income of the consumer remaining constant. The Hicksian substitution effect in now explained with the help of diagram below.

 

 

In this diagram 3.17 the consumer with given money income and given prices of two goods represented by price line PL is in equilibrium at point Q on the indifference curve IC. He buys ON quantity of good Y and OM of good X.

 

We suppose now that the price of good X has fallen and the price of good Y remains the same. With the fall in the price line shifts from PL to PL/. Consumer’s real income is raised because commodity X is cheaper now. This increase in the real income of the consumer is to be wiped out for finding out the substitution effect. The reduction in the money income of the consumer is to be made by so much amount which keeps him on the same indifference curve IC.

 

In case, consumer’s income is reduced by PA (interims of Y) or LB (in terms of X), the consumer will remain on the same indifference curve IC. PA or L/B is the compensating variation in income. At the new price line AB, the consume is in equilibrium at point T. He now buys OM/ of good X and ON/ of good Y.

 

The increase in the purchase of good X by MM/ and decrease in the purchase of good Y by NN/ is due to the fall in the price of good X. The consumer has rearranged his purchase of good X and good Y as good X is now relatively cheaper and good Y is relatively dearer than before.

 

The consumer has moved on the same indifference curve IC from Q to point T substituting the commodity that has become relatively cheaper for the one that has relatively become more expensive because of price change. The type of movement from point Q to T on the same indifference represents the substitution effect.

Comparison Between Indifference Curve Analysis and Marginal Utility Analysis: There is difference of opinion among economists about the superiority of indifference analysis over cardinal utility analysis. Professor Hicks is of the opinion that the indifference analysis is more objective and scientific.  Professor D.H. Rebertson is of the view that the Hicksian indifference curve technique is simply “old wine in new bottle”.  We give in brief the main points of similarly between these two types of analysis and then discuss the superiority of Hicksian indifference curve analysis over the Marshallian Utility Approach. Similarities Between the Two Approaches: (i) Rationality assumption: In the two approaches, it is assumed that the consumer behaves rationality for obtaining satisfaction from his expenditure on consumer goods. Marshall uses the term utility, and Hicks satisfaction. (ii) Proportionality rule: The equilibrium condition of the consumer in both the analysis is the proportionality rule. In cardinal utility analysis , the equilibrium condition of the consumer is: 

MUa / Pa = MUb / Pb = MUc / Pc …………. = MUn / Pn

 In the Hicksian analysis, this ratio of marginal utility has been substituted by marginal rate of substitution is: 

 MRSxy  = Px / Py

 (iii) Diminishing MU and MRS: Another similarity between the two types of analysis is that both assume that as the consumer gets more and more of a commodity, there is diminishing satisfaction to the consumer.

 (iv) Same conclusion: The cardinal utility analysis and the Hicksian indifference curve analysis both reach at the same conclusion about the consumer behavior. There is nothing new in the indifference approach. Superiority of Hicksian Indifference Curve Analysis: The indifference curve analysis is an improved form of utility analysis. It is consider more scientific and particularly accepted able on the following grounds: (i) It dispenses with cardinal measurement of utility: Professor R.G.D. Allen and J.R Hicks claims that the indifference curve technique is scientific and more realistic than the Marshall’s utility analysis. The foundation of utility analysis is based, they say, on the cardinal utility function which assumes that the utility is measurable; whereas utility is purely subjective phenomena and cannot be exactly measured. It varies from person to person and time to time. Any effort to measure it precisely will be a futile one.  On the the other hand, the indifference approach is based on ordinal utility function, i.e., it does not assign any number to a commodity , representing the amount of the utility. It simply assumes that the consumer weighs in his mind the relative desirability of the different combinations of goods and services. (ii) It explains the income effect and price effect: Marshall assumes that the marginal utility of money remains constant whereas the fact is that with a rise or fall in income, the marginal utility of the money changes. The indifference curve approach, however, takes into consideration the income effect changes in price of the commodity. (iii) It studies combination of two goods: It assumed in the Marshallian utility analysis that a consumer can measure the utility of a commodity in isolation from other commodities, i.e., it confines itself to a single commodity model. The indifference curve approach, on the other hand; studies combinations of two goods commodity and analysis the relationship of substitutable and complementarily. (iv) Application of the principle of MRS: The law of diminishing marginal utility has now been replaced by the principle of diminishing marginal rate of substitution. This law is more scientific and realistic and is well applicable in the field of consumption, production and distribution. (v) Popularity of indifference curve technique for the analysis of welfare economies: The indifference curve technique is more popular among the British economists and is mostly used for the analysis of welfare economies. For instance,the indifference curve approach helps us to explain that the direct tax imposes a lesser burden than an indirect tax upon the consumer. (a) The indifference curve approach helps us to explain that the direct tax imposes a lesser burden than an indirect tax upon the consumer. (b) The Hicksian indifference approach is also used for constructing the supply curve of labor in the country. We can explain with the help of indifference technique that when the wages of

the workers rise, they begin to prefer leisure. For example, if wife and husband both work and the wages of the husband increases, wife often leaves the service and begins to do the domestic work. (c) The indifference curve technique is also used for illustrating the concept of consumer's surplus. (d) In case of rationing in the country, the indifference approach tells us that as the income and preferences of consumers differ, therefore, the goods should not be distributed equally. The income and tastes of the consumers should always be kept in view. Criticism of Indifference Curve Approach: The indifference curve approach has been criticized on the following grounds: (i) Old wine in new bottle: Professor D.H. Roberson is of the view that the difference between Marshallian utility analysis and the indifference approach is that an old wine has been put in a new bottle. The only change which Hicks and Allen has made is that they have used the words marginal rate of substitution instead, of marginal utility. (ii) Away from reality: The indifference curve technique is away from reality as the indifference hypothesis are more complicated. (iii) Midway house: Schumpeter describes indifference analysis as a midway house as it particularly no better than the utility analysis. (iii) The consumer is not rational: The consumer is not rational as he acts under various social, economic and legal disabilities. (iv) Two goods model unrealistic: Two goods model unrealistic because a consumer buys large number of commodities to satisfy his unlimited wants. (v) All commodities are not divisible: There is no doubt that indifference curve technique is not without defects, but when we take into consideration the position as a whole, we find that the indifference approach is superior to that of utility approach because it is more realistic and less restrictive.

Consumer's Surplus: Definition and Explanation: The concept of consumer’s surplus was introduced by Alfred Marshall. According to him:

 

"A consumer is generally willing to pay more for a given quantity of good than what he actually pays at the price prevailing in the market".

 

For example, you go to the market for the purchase of a pen. You are mentally prepared to pay $25 for the pen which the seller has shown to you. He offers the pen for $10 only. You immediately purchase the pen and say ‘thank you’.

 

You were willing to pay $25 for the pen but you are delighted to get it for $10 only. Consumer’s surplus is the difference between the maximum amount a consumer is willing to pay for the good and the price he actually pays for the good. In our example given above, the consumer’s surplus is $15 ($25 – $10).

 

Demand Curve and Consumer’s Surplus: The consumer surplus can be easily found out by consumer’s demand curve for the commodity and the current market price which we assume a purchaser cannot change. In the words of Alfred Marshall:

 

“The excess of the price which he (consumer) would be willing to pay rather than go without the thing over that which he actually does pay is the economic measure of this surplus satisfaction”.

 

In the words of A. Koutsoyannis:

 

“Consumer’s surplus is equal to the difference between the amount of money that consumer actually pays to buy a certain quantity rather than go without it”.

 

The concept of consumer’s surplus is the result of two important phenomena:

 

(i) Characteristic of consumer’s behavior. (ii) Characteristic of market. The characteristic of consumer’s behavior is that as he buys more and more of a particular commodity, the marginal utility of the successive units begins to decrease. A rational buyer continuous purchasing the commodity up to the unit which equates his marginal utility of the good to the price he pays for it.

 

The second phenomenon is that there is perfect competition among sellers and a single price prevails in the market for a particular commodity at a particular time. The buyer is able to get the first unit of the commodity at the same price as the second or pay any other unit thereafter.

 

Schedule: 

The concept of consumer’s surplus is now explained with the help of a schedule and a demand curve.

 

Quantity Willing to Pay ($) Price ($) Consumer’s Surplus ($)

1 25 10 15 = (25 – 10)

2 20 10 10 = (20 – 10)

3 15 10 5 = (15 – 10)

4 10 10 0

Total  75 10 x 4 = 40 30

 

Diagram/Figure: 

 

In this figure 3.20, the individual demand curve DD/ shows the maximum amount a consumer is willing to pay for each unit of the good. An individual is not willing to purchase any pen at a price of $30 per month. He will, however, is willing to purchase one pen at a price of $20 per pen, he is willing to purchase 2 pens. The surplus diminishes with the decline in the marginal utility of pens.

 

In case the price comes down to $15 per pen, the consumer purchases 3 pens. By using this demand curve, we measure the surplus which a consumer gets from the purchase of pens. The current market price of a pen $10, which we have assumed the purchaser cannot change. The consumer was willing to pay $25 per pen but he actually pay $10 only, the consumer’s surplus for the first pen is $15 = (25 – 10).

For the second pen, it is $10 = (20 – 10) and for the third consumer’s surplus is $5 = (15 – 10).

 

There is no surplus on the fourth unit as the market price for the pen is the same what he would have paid for the pen. The total consumer’s surplus from the purchase of four pens is $15 + $10 + $5 = $30. It is the sum of surpluses received from each pen. The shaded area in the graph shows the total consumer’s surplus.

 

Criticism: 

The Marshallian concept of consumer’s surplus has been severally criticized by modern economists Allen and Hicks. According to them, the concept is based on assumptions which are unwarranted. Utility, according to them, is a psychological feeling. It cannot be exactly measured in term of money.

 

In Marshallian analysis, the marginal utility of money is assumed to remain constant. The fact is that when a consumer spends money on goods, his income decreases and the marginal utility of money to him rises. Analysis ignores this basic fact.

Consumer’s surplus is said to be imaginary as it assumes that utilities derived from various goods are independent. In real life, this is not true. The fact is that utilities derived from various goods are independent.

 

Measurement of Consumer’s Surplus with the Help of Indifference Curves (Hicksian Method): 

Professor J.R. Hicks, has explained the concept of consumer surplus with the help of indifference curve technique . According to Hicks when there is fall in the price of a commodity, it has two main effects:

 

First, the consumer can purchase more of the good whose price has fallen.

 

Secondly, he can purchase the same quantity of the good as he was buying before but with a lesser amount of money. He spares some money in the bargain. This is a form of rise in the real income of the consumer.

 

Diagram/Figure: 

The Hicksian method of measuring consumer’s surplus is now explained with the help of diagram below.

 

 

In figure 3.20 commodity X is measured on OX axis and money income of an individual on OY axis. We assume here that a consumer does not know the price of the commodity X and has OR quantity of money. The indifference curve IC1 represents various combinations of income and X of commodity X which yield the same level of satisfaction to the consumer.

 

The indifference curve IC1 originates from point R. It shows the stage when the consumer retains all of his income and zero units of commodity for a given level of the utility. The consumer moves down along the curve IC1. The consumer at point P buys OT amount of commodity X and has OE amount of money income. In other words, the consumer is ready to sacrifice RE amount of money for getting OT units of commodity X.

 

We now assume that the consumer is informed of the price of commodity X. The RL is the budget line. The budget line touches the indifference curve IC2 at point N which is the point of equilibrium. The consumer now has the OT commodity of X and OF amount of income. He gives up RF amount of money to buy OT units of commodity X. Previously he was ready to pay RE amount of income which is higher than the amount he pays now. We infer from this that RE – RF i.e., FE is the consumer surplus.

 

FE is the difference between the amount of income the consumer was willing to pay and what he actually pays. The surplus has also shifted the consumer on the higher level of satisfaction from IC1 to IC2.

 

Importance of Consumer’s Surplus: The concept of consumer’s surplus has both theoretical as well as practical importance.

 

(i) Theoretical importance: The idea of consumer’s surplus reveals the benefits which we derive from our purchase of the commodity in the market.

 

For example, when we purchase salt, or a match box, we are willing to pay the amount much higher than their market value. For example, a consumer would be willing to pay $10 for a match box rather than go without it but he actually pay Re one only on the purchase of a match box. Consumer’s surplus on the purchase of match box thus is $ 9.0.

 

(ii) Practical importance: A monopolist can charge higher price for his product if the consumers are enjoying large consumers surplus on the use of his product.

 

(iii) The inhabitants of a country derive consumer's surplus when they import commodities from abroad. They are usually prepared to pay more for than what they actually pay.

 

(iv) A finance minister imposes taxes of the commodities yielding consumer's surplus.

 

(v) An entrepreneur before investing capital in a project evaluates the consumer's surplus to be derived from it. If the benefits to the obtained are greater than the costs, the investment is undertaken.