CBSE Class 11 Economics Utility Analysis and Indifference Curve Analysis Notes

CONSUMER BEHAVIOUR AND DEMAND

UTILITY ANALYSIS AND INDIFFERENCE CURVE ANALYSIS

♦ Introduction to Consumer's Equilibrium

• A consumer is one who buys goods and services for satisfaction of wants.

• The objective of a consumer is to get maximum satisfaction from spending his income on various goods and services, given prices.

• Two approaches are used for getting an answer to this question. These are:

• Utility approach (Cardinal Approach)
   Cardinal Utility: When utility is expressed in exact units
   Ordinal Utility: When utility is expressed in ranks

• Indifference curve approach (Ordinal Approach)

→ Utility Approach

♦ LAW OF DIMINISHING MARGINAL UTILITY (DMU)

• The marginal utility approach is based on the concept of the law of diminishing marginal utility (DMU). Before stating the law, basic facts about utility concepts should be explained.

• Utility: Utility does not mean usefulness. The term utility refers to the want satisfying power of a commodity. It means expected satisfaction to a consumer. Utility differs from person to person, place to place, and time to time. Utility is a cardinal concept i.e., it can be measured as utils.

• Total Utility (TU): It is the total satisfaction or utility that a consumer derives from the consumption. TU can be obtained by the sum of marginal utilities

• Marginal Utility (MU): It is addition made to the total utility as consumption is increased by one more unit of the commodity. The law of diminishing Marginal Utility states that as the consumer has more and more of a commodity the marginal utility of the commodity falls.

MU _n = TU _n -TU _n-1

According to the law, TU increases but at a decreasing rate and MU falls.

• When no unit of X is consumed, TU is zero and MU is maximum

• As the consumer has more of the good, the TU increases and the MU gradually diminishes

• When TU is maximum, MU is zero.
• A rational consumer will stop to consume further because TU will decline and MU will become negative (disutility).

♦  CONSUMER’S EQUILIBRIUM

• Consumer’s equilibrium is defined as the level of consumption where consumer gets maximum satisfaction

• One Commodity Case (when consumer consumes only one commodity)

• Given that utility is a fundamental concept, the MU from different units of a good X can be measured in terms of money. (₹1 = 1 util )

• Px = ₹5 and the consumer buys less than 3 units (units 1 and 2) then his MUx> Px, the consumer buys more.

• If the consumer buys more than 3 units of X (units 4 and 5) then MUx < Px, the consumer will not buy more units of the commodity.

• A consumer will buy that quantity of the good where the MU of the good is equal to the price (MU = Price). Marginal utility of the good= Utility of the price paid.

                                                                                   MUx/Px = MU money

♦ CONSUMER'S EQUILIBRIUM

Two Commodities Case (Law of Equi-marginal utility): Assuming that the consumer consumes only two goods, the conditions required by a consumer to maximise his utility for two commodities X and Y is given as:

(a) MUx = Px (MU money) (1)
     MUy = Py (MU money) (2)

(b) MU diminishes with further consumption

     Divide equation (1) by (2), we get

     MUx/Px = MUy/Py 

The consumer gets the same satisfaction from both the commodities.

A consumer will so allocate his expenditure so that the utility gained from the last rupee spent on each commodity is equal. A consumer buys each commodity up to the point at which MU per rupee spent on it is the same as the MU of a rupee spent on another good. The condition of consumer's equilibrium in case of 2 goods X and Y can be written as:

MUx/Px = MUy/Py = MU of rupee spent on a good

• When this condition is not met, a consumer will adjust the consumption of good X and Good Y in such a way the consumer achieves equilibrium

• When MUx/Px > MUy/Py the consumer will increase consumption of good X and decrease consumption of Good Y till equilibrium is reached

• When  x/Px < MUy/Py the consumer will increase consumption of good y and decrease consumption of Good X till equilibrium is reached

♦ INDIFFERENCE CURVE APPROACH

Indifference Curve

An indifference curve shows different combinations of goods that yield the same level of utility or satisfaction to the consumer.

An indifference curve is downward sloping convex to the origin.

• All points like points A and R on an indifference curve yield same level of satisfaction.

• Any point below the indifference curve (point N) shows an inferior bundle.

• A higher indifference curve shows a greater amount of satisfaction and a lower one lesser satisfaction

Indifference Map

A family of indifference curves is called an Indifference Map. It gives a complete picture of a consumer's scale of preference for two goods. Moving away from the origin moves the consumer to higher levels of utility. Arrow indicates that bundles on higher indifference curves are preferred by the consumer.

Assumptions of Indifference curve

• Rationality. The consumer is assumed to be rational. He aims at maximising his benefits from consumption, given his income and prices of the goods.

• Ordinality. In indifference curve analysis, utility is an ordinal concept. Consumer can order or rank the subjective utilities. A consumer has a scale of preference as between different combinations of the two goods. For example, it there are two goods X and three possibilities exist for the consumer:

X is preferred to Y
Y is preferred to X
X and Yare equally preferred

• Diminishing Marginal Rate of Substitution. The slope of indifference curve is called Marginal Rate of Substitution (MRS) of X for Y. MRS is defined as the amount of good Y the consumer is willing to give up to consume an additional unit of good X, while leaving total utility unchanged.

• Consistency of Choice. Consumer is consistent in his choice. It means that if good X is preferred over good Y in one time period, then consumer will not prefer Y over X in another time period.

• Transitivity of Choice. If good X is preferred to good Y and good Y is preferred to good Z, then good X is preferred to good Z.

• Monotonic Preference. A consumer's preferences are monotonic if and only if between any two bundles, the consumer prefers the bundle which has more of at least one of the goods and no less of the other good as compared is the other bundle.

Preferences of Consumer

• Suppose a consumer has ₹10 and both goods X and Y are priced at ₹2 and are available in integer units.

(a) The bundles that this consumer can afford to buy
(0, 0), (0, 1), (0, 2), (0, 3), (0, 4), (0, 5), (1, 0), (1, 1), (1, 2), (1, 3), (1, 4), (2,0), (2, 1), (2, 2),
(2,3), (3, 0), (3, 1), (3,2), (4,0), (4, 1) and (5,0).

(b) The bundles that cost exactly ₹10
(0,5), (1,4), (2, 3), (3,2), (4, 1), (5,0)

(c) Give two bundles that this consumer cannot afford to buy. (3, 3), (4, 2)

 Please click on below link to download CBSE Class 11 Economics Utility Analysis and Indifference Curve Analysis Notes