Consumer Surplus and Equilibrium

8/3/2019 Consumer Surplus and Equilibrium

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2004 Prentice Hall Publishing Ayers/Collinge, 1/e1

CONSUMER

SURPLUS


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The concept of Consumer

surpluswas first introduced by

Marshall.Consumer surplus

measures the differencebetween what a person is

prepared to pay for a

commodity and the amount he

actually is required to pay.


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The amount that the consumer is

willing to pay for the first unit of the

good he buys is termed as consumers

marginal value . THIS VALUE

DECREASE AS MORE AND MORE

UNITS ARE BOUGHT. A consumer

who maximizes marginal value will

buy to that extent where marginal

value equals price.


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The demand schedule of the product Q is given

below .Estimate the demand Function. If the price is6, What is consumer surplus

Price QUANTITY

5 25

6 20

7 15

8 10


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2004 Prentice Hall Publishing Ayers/Collinge, 1/e

If the demand function for an individual is

P= 16- 0.4Qfor a good . Calculate consumer

surplus for an individual if Q= 20.


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Indifference Curves andIndifference Curves and

equilibrium of consumerequilibrium of consumer

In economic terms, when people areIn economic terms, when people areindifferentindifferentto the choices before them,to the choices before them,they obtain the same amount of utilitythey obtain the same amount of utility

from each of those choices.from each of those choices. AnAn indifference curveindifference curve shows theshows the

combinations of two goods that providecombinations of two goods that providean individual with equal amounts ofan individual with equal amounts ofutility.utility.

An indifference curve slopes downward.An indifference curve slopes downward.


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Assumptions Consumers tastes can be examined with

ordinal utility.

Tastes of consumers are consistent.

More of a commodity is preferred to less.


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Indifference CurvesIndifference Curves


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Characteristics of Indifference

Curves They are generally negatively sloped.

They cannot intersect each other.

The entire set of indifference curve is calledan indifference map.

Indifference curves are usually convex to

the origin. Convexity results from or is areflection of a decreasing marginal rate ofsubstitution.


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The Marginal Rate of SubstitutionThe Marginal Rate of Substitution

The marginal rate of substitutionThe marginal rate of substitution is the quantityis the quantity

of one good that must be given up as theof one good that must be given up as the

consumption of the other good increases byconsumption of the other good increases by

one unit and total utility remains constant.one unit and total utility remains constant.

The marginal rate of substitution can beThe marginal rate of substitution can be

expressed as:expressed as:

Marginal rate ofMarginal rate of

substitutionsubstitution==

Change in the consumption of one goodChange in the consumption of one good

Change in the consumption of another goodChange in the consumption of another good


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The Marginal Rate of SubstitutionThe Marginal Rate of Substitution

DiminishesDiminishes

The marginal rate of substitution is an approximation forThe marginal rate of substitution is an approximation for

the absolute value of the slope of an indifference curve.the absolute value of the slope of an indifference curve.

(A) (B) (C) (D)

BETWEEN

POINTS:

CHANGE IN

CONSUMPTION

OF JUMBOSHRIMP

CHANGE IN

CONSUMPTION

OF CHICKENWINGS

MARGINAL

RATE OF

SUBSTITUTION= (C/B)

A and B (2-1) = 1 (5-8) = -3 3

B and C (3-2) = 1 (3-5) = -2 2

C and D (4-3) = 1 (2-3) = -1 1


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Indifference MapsIndifference Maps

AnAn indifference mapindifference map shows a set of indifferenceshows a set of indifferencecurves.curves.

AnAn indifference curveindifference curve shows combinations of two goodsshows combinations of two goodsthat are equally preferred by the consumer.that are equally preferred by the consumer.

They slope downward and are convex to the origin, notThey slope downward and are convex to the origin, notstraight lines.straight lines.

They can be characterized by the marginal rate ofThey can be characterized by the marginal rate ofsubstitution, an approximation to the absolute value ofsubstitution, an approximation to the absolute value ofits slope. That slope varies along an indifference curve.its slope. That slope varies along an indifference curve.

A consumer s indifference map will have manyA consumer s indifference map will have manyindifference curves, each indicating a different level ofindifference curves, each indicating a different level ofutility. Higher utility is shown by indifference curvesutility. Higher utility is shown by indifference curvesfarther from the origin.farther from the origin.


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Indifference MapsIndifference Maps

More is

better

Good 1

Good 2

Indifference

curves


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Some special types of indifferent

curves Horizontal(X is neutral)

Vertical(Y is neutral)

Negatively sloped straight (MRSxy is

constant)goods are perfect substitute.

Concave to origin. (MRSxy is increasing)

L-shaped(Complementary goods)


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Budget ConstraintsBudget Constraints

TheThe budget constraintbudget constraintis a curve that shows a consumersis a curve that shows a consumers

consumption possibilities for two goods.Given the income ofconsumption possibilities for two goods.Given the income of

consumer and price of two commodityconsumer and price of two commodity

Consumer choice is limited by the amount of money thatConsumer choice is limited by the amount of money thatpeople can spend and the prices of the goods they buy.Pxpeople can spend and the prices of the goods they buy.Px

.Qx+Py.Qy=I.Qx+Py.Qy=I

Points outside the budget constraint require more incomePoints outside the budget constraint require more income

than is currently available and thus cannot be purchasedthan is currently available and thus cannot be purchasednow.now.

The slope of the budget constraint in absolute value termsThe slope of the budget constraint in absolute value terms

equals the ratio of the prices of the two goodsequals the ratio of the prices of the two goods..


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Equation for budget constrain M= Px.X+ Py.Y

Y= M/Py Px/ Py.X


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The budget constraint will bea downward-sloping straightline, withthe

slopeequalto -(price of one good/price ofanothergood).

The slope of Rays budget

constraintis

-(price of shrimp/price of wings)

= -1/.25 = -4.


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The budget constraint will shiftin a

parallelmannerifincome changes

orwill pivotif one ofthe prices

changes.In theexamples shown,a decrease

in income shifts the budgetconstraintinward.

Alternatively,ifthe shrimp price

doubles,the budget constraint pivots

inward untilitintersects the shrimp axis

athalfthe numberof shrimp that couldpreviouslyhave been purchased.


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Utility Maximization and

Consumers Equilibrium A consumer is in equilibrium when, given

personal income and price constraints, the

consumer maximizes total utility or

satisfaction from his or her expenditure. In

other words, a consumer is in equilibrium

when, given his or her budget line, theperson reaches the highest possible

indifference curve.


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Price Effect , Income Effect , Substitution

Effect

Income Consumption Curve

Price consumption curve

Derivation of demand curve

Price effect- Income and consumption effect


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Class of 2007

A

consumer has a monthly budget ofRs. 200 for buying commodities A and

. Prices ofA and B are Rs 2 and Rs 3

respectively. His utility function is U=4AB

With the objective of maximizing the

utility , determine how the consumer

would allocate the budget .


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Class of 2008

If an individual consumersutility function is

U= X1X2

Money income is Rs 20, while

the price are P1= Rs 2.00 andP2= Rs 8.00 , determine the

utility maximizing choice .


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Class of 2007

Assume that the utility function ofMr. Ray is U= q1q2and price of the

commodity q1 ,P1= Rs 2 and price

of the commodity q2,P2 = 5and theincome of Mr. Ray is Rs 100. Point

out two utility maximizing condition

and also find the optimal

commodity purchases that

maximizes the Utility of Mr Rai.


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Sheela has a monthly income of Rs 1000 that

she allocates among two goods : Wheat flour

and vegetables .

a. Suppose wheat flour costs Rs 10 per Kg and

Vegetables cost Rs 5 per kg . Draw her budget

constraint .

b. Suppose also her utility function is given by the

equation u (W,V)= 2W+ V . What combination

of wheat and vegetables should she buy tomaximize her utility( Wheat and vegetables are

perfect substitute )


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If the utility function of a consumer is U=

X2+Y2+XY. Income of the consumer is Rs

500. If the price of the commodity X is Rs 2and commodity Y Rs 3 , then find out the

optimum quantity X and Y.


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The following table shows the MU OF X and Y of an individual

Units MUx MUy

1 16 152 14 13

3 11 12

4 10 85 9 6

6 8 5

7 7 4

8 6 3

9 5 2

10 3 1

11 1 0


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Suppose the price of X and Y are Rs 2. Individual hasincome Rs 20 and spends all his income .

a. State the equilibrium condition for the individual

b. If commodity Y is saving how would theequilibrium condition will be affected

c. Suppose the MU of fourth unit of Y was 7 utils

rather than 8. What effect it would have on theequilibrium condition .

d. Suppose the MU increased of X as consumerconsumes more of X While MU of Y remainsunchanged

e. Over what range of the MU function do consumersoperate

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Consumer Surplus and Equilibrium

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