Consumer Equilibrium Using Indifference Curve Analysis
Consumer equilibrium using indifference curve analysis is at a point where the consumer indifference curve touches the budget line. We have done consumer theory, consumer equilibrium using utility analysis, the law of diminishing marginal utility, indifference curve, and today we will learn another type of consumer equilibrium with the indifference curve approach. The indifference curve approach other name is ordinal utility analysis. For explaining consumer equilibrium, you need to write the basic statement, conditions, derivation, and diagrammatic presentation. Let’s learn each of these.
The Statement for Consumer Equilibrium using Indifference Curve Analysis
As I mentioned, Consumer equilibrium with the help of indifference curve analysis (Ordinal utility analysis) is at a point where the consumer’s indifference curve touches (Tangent means only touches at one point) the budget line.
Conditions for Consumer Equilibrium by IC Analysis
- The budget line should be tangent to the indifference curve.
- The indifference curve (IC) should be convex to the origin.
- The slope of the Indifference curve (MRS) should be equal to the slope of the budget line (-P1/P2)
Derivation of the Consumer Equilibrium
- A consumer is in equilibrium when according to the budget line, he moves to the highest possible indifference curve (IC2).
- As shown below, point E is a point of equilibrium that satisfies all conditions.
- At point E, the budget line (AB) is tangent to the indifference curve(IC2), (convex shaped).
- At point E, the slope of IC2= slope of the budget line. That is the Marginal Rate of substitution = -P1/P2 (Sometimes, minus sign is ignored because MRS is also negative, and slope of the budget line is also negative, which cancels each other).
- The consumer will never operate on IC1 because this is under the budget line and by the property of the indifference curve: higher is always preferred to the lower ones.
- The consumer will never operate on IC3 because this is beyond the budget line, and he cannot afford it.
- Hence, the consumer reaches equilibrium on IC2, which is touching the budget line at point E, indicating consumer equilibrium under IC analysis.
What are monotonic preferences?
Monotonic preferences refer to a situation in which a consumer will prefer the bundle of goods which contains more of both goods, or more of at least one good and same amount of the other good. For example, if bundle A is (5,4), and bundle B is (4,4). A consumer will always prefer bundle A over bundle B. We write these preferences as A> B; consumers choose Bundle A over bundle B (Why? Because in bundle A, we have 5 units of good 1, whereas in bundle B we have 4 units of good 1).