Consumer’s Equilibrium through Indifference Curve Approach / Hicksian Approach: Economics notes class11-12

 Consumer’s Equilibrium through Indifference Curve Approach / Hicksian Approach  :

     The utility approach was based on the assumption that utility is measurable numerically, this is called Cardinal Utility Approach.

     Prof. J. R Hicks criticised the utility approach as unrealistic because  satisfaction (utility)  is a subjective phenomenon and so it can never be measured precisely.

     He therefore, presented an alternative technique known as Indifference Curve approach (Ordinal Utility approach). It is based on the assumption that every consumer has a scale of preference in the form of assigning ranks to different combinations of two goods called bundle and he can tell which bundle he likes most.

    Since the approach is given by J. R. Hicks, it is known as Hicksian Approach. According to which – 

  ” A consumer attains his equilibrium when he maximise his total utility given his income and prices of the two commodities.”

     This approach uses consumers indifference map and budget line to explain consumer’s equilibrium. Given the amount of money which consumer wants to spend on two commodities and given the prices of the two commodities, we can draw a budget line.

     The budget line shows the various combinations which the consumer can afford to buy with his given budget and given prices of the two goods, the indifference map shows the consumer’s scale of preference between various combinations of the two goods.

      Indifference curve approach / Hicksian approach explains consumer’s indifference map and the budget line.

 Conditions of Consumer’s Equilibrium  :

        The consumer’s equilibrium is attained at a level of consumption where the following conditions are fulfilled —

  1.   MRSxy  = Ratio of Prices 

       MRSxy = Px / Py

   Slope of indifference curve = slope of budget line 

      Let the two goods be X and Y. The first condition for consumer’s equilibrium is that 

          MRSxy = Px/ Py 

   # If MRS >Px/Py

    It means that the consumer is willing to pay more for X than the price prevailing in the market. As a result, the consumer buys more of X. As a result MRS falls till it becomes equal to the ratio of prices and the equilibrium is established.

    # If MRS < Px /Py  

   It means the consumer is Willing to pay less for X than the price prevailing in the market. It induces the consumer to buy less of X and more of Y. As a result, MRS rises till it becomes equal to the ratio of prices and the equilibrium is established.

   2. Diminishing MRSxy or diminishing marginal rate of Substitution of X for Y –

   At the point of equilibrium the MRSxy should be diminishing i.e. the indifference curve must be convex to the origin. Unless MRS continuously falls, the equilibrium can not be established.

    Thus, both the conditions need to be fulfilled for a consumer to be in equilibrium.

 Assumptions  :

   1. Consumer is rational i.e. he tends to maximise his total satisfaction by attaining highest possible indifference curve. 

   2. Utility is not cardinally measured but it can be put in order of preferences i.e. ordinal measurability.

   3. Non -satiety –  which means consumer is never fully satisfied, thus will always prefer larger amount to smaller   amount.

  4. Transitivity of choice – Consumer prefers combination   A to B and combination B to C then he would prefer A to C also.

Explanation : 

 

• In the given Indifference Map, the consumer tend to prefer the highest IC  means IC3. This is based on the property  – Higher IC represents higher level of satisfaction.

• But the consumer is restricted by his budget constraints given y the budget line AB.

• Any combination on IC3 will be desirable but not affordable. Because it would lie on outside the budget line. 

• Combination lying within AB are affordable but consumer will not be at equilibrium as the entire income is not spent.  

• The equilibrium thus would be at any combination lying on the budget line.

• Combination E is the consumer’s equilibrium as it lies on the highest IC which can be reached given the budget constraints of the consumer. Both the conditions of equilibrium mentioned are met here. #Slope of IC = MRSxy = Px /Py = slope of the budget line

      #Diminishing MRSxy i.e. the IC is convex to the origin at the tangency. 

• Combination F and G though lying on the budget line but cannot be the level of maximum satisfaction as these points lie on a lower IC also.

• At point a, MRSxy > Px/Py

•    A utility maximising consumer should choose a point where he would get maximum satisfaction. That point lies on IC3.

• But since the point lies outside the budget line, and the consumer is restricted by his budget constraint. So any combination on IC3 is not affordable.

• All the combinations that lie on the Budget line AB are affordable but the consumer will not be at equilibrium as the entire income is not spent.

• The equilibrium thus would be at any combination lying on the budget line.

• Combination E is the consumer’s equilibrium as it lies on the highest IC which can be reached given the budget constraint of the consumer. 

• Combination F and G though lying on the budget line can not be at the maximum level of satisfaction as these lie on a lower IC.

•  These points are not tangency point of  IC1 , so the consumer would get maximum utility at the tangency point where 

           MRSxy = Px / Py

• At the tangency point the convexity of IC is maximum means        MRSxy  = Px/Py