Modern economists have disregarded the concept of ‘cardinal measure of utility’. They have come to believe that utility is a psychological phenomenon that is next to impossible to measure in absolute terms. Instead, they believe that a consumer can rank various combinations of goods and services in order of their preference. This approach does not use cardinal values like 1, 2, 3, 4, etc. Rather, it makes use of ordinal numbers like 1st, 2nd, 3rd, 4th, etc. which can be used only for ranking. Such a method of ranking preferences is known as the ‘ordinal utility approach’.
Before determining the consumer’s equilibrium through this approach, it is important to understand some useful concepts related to Indifference Curve Analysis.
What is Indifference Curve?
When a consumer consumes various goods and services, there are some combinations which give them exactly the same total satisfaction. The graphical representation of such combinations is termed as indifference curve. Indifference curve refers to the graphical representation of various alternative combinations of bundles of two goods among which the consumer is indifferent. Alternately, an indifference curve is a locus of points that show such combinations of two commodities which give the consumer the same satisfaction.
For example, if a consumer consumes two goods, Apples and Bananas, then they can indicate:
- Whether they prefer apple over banana; or
- Whether they prefer banana over apple; or
- Whether they are indifferent between apples and bananas, i.e. both are equally preferable and both of them give them the same level of satisfaction.
Monotonic preference means that a rational consumer always prefers more of a commodity as it offers them a higher level of satisfaction. Monotonic preferences imply that as consumption increases, total utility also increases. For instance, a consumer’s preferences are monotonic only when between any two bundles, they prefer the bundle which has more of at least one of the goods and no less of the other good as compared to the other bundle.
Example: Consider 2 goods:
Apples (A) and Bananas (B).
(a) Suppose two different bundles are: 1st: (10A, 10B); and 2nd: (7A, 7B).
Consumer’s preference of 1st bundle as compared to 2nd bundle will be called monotonic preference as 1st bundle contains more of both apples and bananas.
Consumer’s Equilibrium through Indifference Curve Analysis
Consumer’s equilibrium refers to that bundle of goods and services, which gives the consumer maximum satisfaction or utility. In other words, consumer’s equilibrium is achieved when the consumer is consuming the combination of goods and services that provides him with the highest level of satisfaction, given his income and the prices of goods and services in the market.
Consumer’s equilibrium can be achieved with the help of indifference curve analysis. Let us understand the consumer’s equilibrium with the help of an example.
Suppose there are only two goods, ‘X’ and ‘Y’ and the consumer has Rs. 100 to spend on these goods. The prices of X and Y are Rs. 10 and Rs. 5 per unit, respectively.
Now, we need to find out at which point the consumer will achieve the equilibrium. For this, we need to use the concept of marginal rate of substitution (MRS).
Marginal Rate of Substitution (MRS)
Marginal rate of substitution (MRS) refers to the rate at which the consumer is willing to exchange one good for another while keeping the level of satisfaction constant. In other words, it is the amount of one good that the consumer is willing to sacrifice for an additional unit of another good.
MRS can be calculated as the ratio of the marginal utilities of two goods. The marginal utility of a good refers to the additional utility derived from the consumption of an additional unit of the good, keeping the consumption of other goods constant.
MRS = MUx/MUy
where MUx is the marginal utility of good X and MUy is the marginal utility of good Y.
Consumer’s equilibrium can be achieved at the point where the MRS is equal to the ratio of the prices of the two goods.
MRS = Px/Py
where Px is the price of good X and Py is the price of good Y.
At the point of equilibrium, the consumer is consuming the combination of goods that provides him with the highest level of satisfaction given his income and the prices of goods in the market. At this point, the MRS is equal to the ratio of the prices of the two goods.
The MRS is also influenced by the shape of the indifference curve. In the case of a convex indifference curve, the MRS decreases as we move down along the curve. This implies that as the consumer moves down the curve, he or she is willing to give up less of one good in exchange for the other.
On the other hand, in the case of a concave indifference curve, the MRS increases as we move down along the curve. This implies that as the consumer moves down the curve, he or she is willing to give up more of one good in exchange for the other.
The concept of the marginal rate of substitution is important in determining the consumer’s equilibrium. The consumer’s equilibrium is achieved when the MRS between any two goods is equal to the ratio of their prices. This is because the consumer will allocate his or her income in such a way that the MRS of any two goods is equal to the ratio of their prices.
If the MRS is greater than the price ratio, the consumer can increase his or her satisfaction by consuming more of the cheaper good and less of the expensive good. If the MRS is less than the price ratio, the consumer can increase his or her satisfaction by consuming more of the expensive good and less of the cheaper good.