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Economics - Theory of the Consumer

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    Study Guide Economics – Theory of the Consumer 1. Consumer Equilibrium 1 .1 What Is Consumer Equilibrium? When consumers decide how much of different goods and services to buy, their main goal is to get the maximum possible satisfaction , also called total utility . However, consumers cannot buy everything they want. They face two main limitations: • Limited income (budget) • Prices of goods and services Trying to get the highest total utility while staying within these limits is called the consumer’s problem . The solution to this problem — where the consumer chooses the best combination of goods — is known as consumer equilibrium . 1.2 How Is Consumer Equilibrium Determined? To understand this idea clearly, let us start with a simple case. Suppose a consumer buys only two goods : • Good 1 • Good 2 The consumer: • Knows the prices of both goods • Has a fixed budget • Spends the entire budget on these two goods The consumer reaches equilibrium when the satisfaction gained from the last rupee spent on each good is the same . In other words, the consumer distributes spending so that: The marginal utility per rupee spent on Good 1 is equal to the marginal utility per rupee spent on Good 2.

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    Study Guide 1.3 Why Must Marginal Utility per Rupee Be Equal? If the marginal utility per rupee from Good 1 is higher than that from Good 2 , the consumer will buy more of Good 1 and less of Good 2. As the consumer buys more units of Good 1: • The law of diminishing marginal utility applies • Marginal utility from Good 1 gradually falls This process continues until: • The marginal utility per rupee spent on both goods becomes equal At this point, the consumer is making the best possible use of income , given prices and budget. 1.4 An Example of Consumer Equilibrium Let us now understand this with a numerical example. Given: • Price of Good 1 = $2 per unit • Price of Good 2 = $1 per unit • Consumer’s budget = $5 Marginal utility (MU) is measured in imaginary units called utils . More utils mean more satisfaction from consuming a unit of a good.

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    Study Guide 1.5 Understanding the Table From the table: • The first unit of Good 1 gives 24 utils • Price of Good 1 is $2 • So, MU per dollar = 24 ÷ 2 = 12 utils Similarly, MU per dollar is calculated for all units of both goods. Step - by - Step Consumer Decision 1. First purchase o MU per dollar of Good 1 = 12 utils o MU per dollar of Good 2 = 9 utils o Good 1 gives more satisfaction per dollar, so the consumer buys 1 unit of Good 1 o Money left = $5 − $2 = $3 2. Second decision o MU per dollar of second unit of Good 1 = 9 utils o MU per dollar of first unit of Good 2 = 9 utils o Both give equal satisfaction, so the consumer buys both o Cost = $2 + $1 = $3

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    Study Guide 3. Budget exhausted o Total spending = $5 o MU per dollar from both goods is equal 1.6 Final Equilibrium Choice At equilibrium, the consumer buys: • 2 units of Good 1 • 1 unit of Good 2 This combination: • Uses the full budget • Gives maximum total utility • Equalizes marginal utility per dollar spent 1.7 Consumer Equilibrium with Many Goods In real life, consumers usually buy more than two goods . When there are N goods , the rule remains the same: The consumer is in equilibrium when the marginal utility per rupee spent on each good is equal , subject to the budget constraint . Key Takeaway • Consumers aim to maximize satisfaction • Income and prices limit choices • Equal marginal utility per rupee spent is the key rule • This rule applies to two goods or many goods

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    Study Guide 2. Consumer Equilibrium Changes in Prices The table helps students clearly see how marginal utility per dollar changes when prices change. 2.1 Understanding Consumer Choices When Prices Change Consumers choose how much of different goods to buy so that they get the maximum total satisfaction (utility) from their limited income. This choice depends mainly on two things: • The prices of goods , and • The consumer’s budget . When the price of any good changes, the consumer’s best (equilibrium) choice also changes. Let’s understand this step by step using a simple example. 2.2 A Change in the Price of Good 1 In our example, the consumer buys Good 1 and Good 2 . • The price of Good 1 increases from $2 to $3 per unit • The price of Good 2 stays the same at $1 per unit • The consumer’s budget remains $5 • The marginal utilities of both goods do not change What does change is the marginal utility per dollar spent on Good 1 . Since Good 1 is now more expensive, each dollar spent on it gives less satisfaction than before .

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