Consumer Equilibrium, Indifference Curve, and Consumer Behaviour

Meaning of Consumer Equilibrium

Consumer equilibrium means that you are completely satisfied with the way you are spending your money. It happens when you are enjoying the utmost happiness from goods and services within your limited budget.

• You feel no regrets for the way you have spent your money.
• You are utterly confident that you cannot get more satisfaction by spending the money in some other way.
• You do not want to switch to another combination of goods and services.

For example, you have Rs 100 in your pocket.

You want to purchase chocolates and ice cream with that money.

The price of ice cream is 20, and that of a chocolate is 10.

You will buy 3 cups of ice cream and 4 chocolates. But you are unable to enjoy the 3rd cup of ice cream, and it goes to waste. With the chocolates, you feel very happy and content. You feel that you could have enjoyed two more chocolates instead. 

So, the next time, you will buy 2 cups of ice cream and 6 chocolates. You feel completely satisfied and happy with your choice. This level of satisfaction is known as "Consumer Equilibrium" in economics.

Consumer Equilibrium Definition

Consumer equilibrium is the point of maximum satisfaction where a consumer attains the highest possible utility within their limited income. It represents the situation where the consumer can purchase the optimal quantity of goods and services available at current prices, given their income level.

Conditions for a Single Product:

The consumer has a fixed amount of money to spend, and the extra satisfaction (marginal utility) from the last rupee spent equals the price of the good.

Formula: Marginal Utility (MU) = Price (P).

Conditions for Multiple Products: 

All products have equal per-rupee utility, and the satisfaction gained per rupee spent is the same across all purchased items.

If there are two goods X and Y, and the Price of each is P, then the marginal utility of good X divided by the Price of good X will be equal to the marginal utility of good Y divided by the Price of good Y

So, the Formula for Multiple Products is MUX/PX = MUY/PY

It means that the marginal utility derived from good X equals the marginal utility from good Y. 

This applies to any number of products(goods) under Consumer Equilibrium.   

Assumptions underlying Consumer's Equilibrium

The following are some of the assumptions implicit in consumer equilibrium.

• The consumer's income is given, and He has to spend within that income.
• The prices are set and stable for the time being under study.
• It is assumed that he has to choose only from various combinations of products available in the market during that particular time.
• The availability of goods and the time gap play an important role along with his income levels.

Marginal Utility is measured in units, and these units are called Utils. So, you can say that you enjoyed a marginal utility of 60 Utils from your ice cream if you ate two ice creams and their utilities were 100 utils for the first ice cream and 60 for the second one.

There are two ways of viewing marginal utility:

1. The Cardinal View (Numbers): 

You give numbers to the utility derived: 100 utils, 60 utils, 30 utils, etc. 

But many economists argue that you can not actually visualise and count the satisfaction derived using numbers. They are only assumptions.

2. The Ordinal View (Rankings):

This is the modern, realistic approach. It assumes you can not measure utility in numbers, but you can rank them.

Indifference Curve

An indifference curve is a curve formed on a graph by connecting the points of different combinations of two commodities that a consumer regards as of equal value and are giving him equal satisfaction. The consumer regards any combination on that curve as of equal value, and so he is indifferent to each of those combinations.

With a given income and the present ranges of prices, the consumer has to choose among various alternative combinations of goods and services to derive utmost satisfaction and enjoy most of those goods and services. 

The manner in which he responds and the solution that he finds at a particular level with a given combination is his equilibrium.

Indifference Curve Example

Now, let us take an example. Suppose your income is $100 and you have to purchase two goods within that income. 

Let us assume that the price of product X is $10, and that of product Y is $20. 

Now, if you want to purchase only one commodity, then you can purchase either 10 units of X or 5 units of Y. 

But you can't have only one item. You have to buy both items to maximise your satisfaction levels. So, you will try different combinations of those goods, and the results are depicted through the indifference curves in the indifference map below.

In the figure above, the X-axis represents product X and the Y-axis represents product Y. At the right-hand tip of each curve, IC stands for the indifference curve. We have drawn four indifference curves, labeled IC1, IC2, IC3, and IC4. You will notice that points on IC1, IC2, and IC3 fall within your income range. However, IC4 is completely outside your income range, as it lies beyond the price line. The price line AB is tangent to the indifference curve IC3 at point E. Therefore, point E can be considered the consumer equilibrium point, at which the consumer maximizes satisfaction by purchasing Q1 units of product X and Q2 units of product Y. Any other points on lower levels that touch the price line will yield less satisfaction. Furthermore, at those points, the consumer is not spending his full income. Points at higher levels do not touch the price line AB and so are not within his income range.

To Sum-Up,

Consumer equilibrium is the point at which the consumer maximizes satisfaction by spending his full income on those products in the most effective way. In real life, there are so many products that the buyer purchases, and it is a more complicated problem. The decision-making ability of the consumer shows his smartness and prudence in attaining consumer equilibrium.

Pricing Process: Ever Wondered How Businesses Set Their Prices?

How Do They Set Their Prices?

 
While sitting in a Cafe and drinking a cup of Coffee, have you ever wondered why that cup of coffee costs so much?

Businesses just won't come up with a figure by magic to set their prices.

It is not a simple job for the producers or sellers to set a particular price for their products. It involves a lot of calculations that involve science, math, and customer feelings.

Businessmen have to consider many factors before arriving at a price. They are doing business to earn their living. They have to earn some extra income beyond what they are spending on their business. 

So, how do they arrive at their price tags?

Let us take a peek into the process of setting the prices. For this purpose, I am taking the example of a recipe, say, idli and its side dish, chutney.

Determining the Cost of Idli

Ingredients required for preparing this breakfast recipe (for 10 idlis) are as follows:

• Black gram (split lentil) 100 grams = Rs 40
• Idli Rawa                        200 grams = Rs 20
• Coconut pieces (for chutney) 50 grams = Rs 30
• Green chili & ginger (for chutney) approx. = Rs 10
• Roasted chana dal 20 grams             = Rs 10
• Salt & spices used for topping chutney = Rs 10

Total Cost of Ingredients (Raw Materials)    = Rs 120

Now, add your time and labour invested, say   Rs  50

Add the fuel cost and rent for utensils, say       Rs  30

                          

                  Total cost of preparing 10 idlis   = Rs 200

                                                                       ________

                  So, cost of one idli is  200/10     = Rs 10

This is how businesses determine prices for products.

The above is a single example for your understanding. In actual practice, the process can be more complex. 

1. The cost of raw materials is the primary input.
2. Thereafter, add other costs like power and fuel consumed during production.
3. Add the labour cost involved.
4. Add the rent/depreciation for machinery and equipment used.
5. Calculate other expenses incurred in producing the output and include them also in the total cost.
6. Total up the expenses cited above and divide by the quantity produced. 
7. The average cost is the basic price for your product.
8. But you are doing the business to earn your livelihood. Your income/profit is the main objective.
9. Increase the sale price by the minimum average amount of that profit margin. This is the Price at which you should sell your product.

From the above example, I hope it is clear to you in understanding the pricing process of goods and services.

Many external factors also need to be considered while determining the prices. Let us look into them.

Factors Influencing Price Determination

The following are some of the most important factors affecting price determination:

1) Cost of production
Cost of production is the basic element of price, as discussed above.

But there should be a periodic review of the cost. The prices of the ingredients are ever-fluctuating. Salaries and wages keep changing. Other overhead expenses also keep fluctuating. A continuous moniteering should be done to ascertain that you are recovering the costs from the sales.

2) Competition in Market

You are not the only businessman for your products. The same products are produced and sold by many others. 

If there are many sellers of the same commodity, each one of them will be trying to maximise his sales by giving incentives to buyers. 

Buyers generally buy from a dealer who offers the products at comparatively lower prices. Even a small fraction of a rupee charged less can allure the buyers. 

So, the producer or seller needs to pay attention to this factor of market competition while setting his prices.

3) Value of Product to the Buyer
This is another important element in fixing the price. 

The value that buyers attach to the product is a very sensitive element of price. 

Necessities like food grains, salt, and sugar are more important for consumers. So, they cannot live without these products. 

Similarly, bridal wear, birthday gift items, and children's toys can be important items for the customers. They would like to pay a little more than foregoing such items. 

The producer or supplier can set the prices of such goods with ample margins without losing market share.

4) The Forces of Supply and Demand

The forces of demand and supply play a major role in price determination. 

Buyers normally tend to purchase products at reasonably lower prices to get maximum satisfaction.

Similarly, sellers try to maximise their profits by selling things at higher prices. 

So, when both these forces clash, buyers try to restrict their purchases whenever prices rise, or try to increase their purchases when prices fall. 

Naturally, when there are no buyers at increased prices, the supplier is forced to reduce their price a little to attract buyers. 

Similarly, when prices fall too much, there will be excessive demand for products, but the supplier may not have enough supply to meet that demand. The markets may become out of stock. Under such circumstances, buyers will be ready to pay a slightly higher price. Thereby, the prices will increase. 

In this way, the price level settles at a point of equilibrium where quantity demanded and quantity supplied match up.

Thus, the forces of supply and demand have an effect on the price structures of markets.

5) Government Policies

The government can always try to regulate prices through its policies and laws to safeguard the interests of consumers. So, producers and sellers have to set their prices in accordance with those policies and guidelines, or else they may face legal proceedings and bans.

The Law of Demand, Demand Schedule, and Demand Curve

Meaning and Definition of the Law of Demand

The law of demand states the relationship between the price of a commodity and the quantity demanded of it. 

It studies and explains the spending and purchasing habits of consumers at any time.

Whereas suppliers of goods and services tend to increase the supply of their products to the market (as a result of the increase in prices), consumers tend to react inversely. 

Consumers shrink their demand for goods and services whose prices have begun to increase.

This decrease in demand happens because consumers have to make purchases within their own financial limits. Naturally, they tend to curtail their purchases of costly items and shift their attention towards lower-cost commodities.

The law of demand is based on this trend of decreasing demand for goods and services whose prices are spiralling upwards.

So, the law of demand and the law of supply are inversely related to each other.

Definition of The Law of Demand

The law of demand states that, other factors remaining constant, as the price of a good or service increases, consumer demand for it will decrease. 

So, according to this law of demand, the price of a commodity and the demanded quantity are inversely related to each other. 

If the price rises, demand for the quantity will decrease, and if the price falls, the demanded quantity will increase.

• The demand for any commodity is expressed as @ the rate of its price and at a particular point in time or during a given period of time.
• Or, in other words, the demand for any quantity is to be mentioned in terms of its price at a particular point in time or during a given period of time.

Example:

The demanded quantity of sugar was 100 kg @ 30/per kg as at 9 AM. At 12 Noon, the demand was 80 kg @ 35/per kg.

Demand for sugar during the period 10 AM to 12 Noon was 200 kg @ 30/per kg.

Demand Schedule

A demand schedule is a chart showing various prices of a commodity and the quantities demanded at each price range.

Let me give an example here.

Suppose a consumer goes to purchase Sugar. He buys 5 kg of sugar when the price is Rs.30 per kg. Suppose the price increases to Rs. 40. 

Then he will buy only 4 kg, and if the price increases to Rs. 50, he will buy only 3 kg. 

As the price goes on increasing, he goes on decreasing his consumption. 

Or, conversely, when the prices fall, he will increase the quantity of purchases. 

The same thing can be represented in the demand schedule as below.

Demand Schedule for Sugar                                                      

Price of sugar	Qty. demanded
30	5 kg
40	4 kg
50	3 kg

The above example is for a particular person's individual demand. So, if we consider the demand of other people also for the commodity of Sugar, then it will be deemed as the total market demand for sugar. Suppose there are 10 people and each one demands various quantities at each price level. Then, you will have to add all the quantities demanded by all people for each price level to know the total demand at each price level. This is known as market demand for sugar. 

Demand Curve

A demand curve is a graph representing the relationship between the price of a commodity and the quantity demanded by consumers at each price level of that commodity. It is a graphical representation of the demand schedule.

So, from the above figures of demand for sugar at different prices, we can prepare the demand curve as shown in the figure below.

Demand Curve for Sugar

In the figure above (drawn by me by hand), the demand curve is the slant line at the top-right corner of the image. It slopes downward because, with every increase in price, demand decreases.

Regarding factors affecting supply and demand, you may view for details at this link.