In: Economics

# Consumer's Equilibrium by Diminishing Marginal Utility and Consumer's Surplus in Economy.

How does a consumer attain equilibrium by way of Law of Diminishing Marginal Utility? Elaborate.

What is the meaning of consumer's surplus? How do we calculate it by the concept of Diminishing Utility? How do price changes affect consumer's surplus?

## Solutions

##### Expert Solution

Consumer's Equilibrium by Diminishing Marginal Utility

The Law of diminishing marginal utility, helps us understand the behaviour of the consumer and we can also find the consumer's equilibrium with the help of this concept. If the marginal utility is assumed to be expressed in money terms, and the price of the commodity to be given, then we can determine the consumer's equilibrium. We show it in the following table -1

Table -1

(Marginal Utility and Consumer's Equilibrium)

 No. of Units Consumed Marginal Utility (in $) 1 15 2 14 3 11 4 10 5 8 6 7 7 5 8 3 9 1 10 0 If, suppose, the price of the commodity is$8, then the consumer would like to consume the first unit because he gets a utility of $15 while he pays only$8 (the price), hence it is beneficial for him. Similarly, he would like to consume second unit also because the utility derived is greater than the price paid. For the same reason, he would like to consume 3rd, 4th and 5th units because the utility derived is greater than or equal to the price paid. He would not consume more than units because, then the utility derived becomes less than the rice paid. In this way, the consumer would get his equilibrium at 5 units. So, we can say that the consumer would get its equilibrium where,

P  =  MU

or

Price is equal to the MU of the commodity.

On the basis of this equation we can say that when the price in $10, he would consume 4 units; if the price is$8, he would consume 5 units; at the price of $7 he would consume 6 units and if the price is zero, he would consumer maximum 10 units. This shows that as the price decreases, his consumption would go on increasing. CONSUMER'S SURPLUS - The principle of diminishing marginal utility led to the concept of consumer's surplus. Athough, this concept was first given by Dupuit in 1842, but it was really refined and developed by Marshall. Marshall defines consumer surplus as the excess of the price which he (consumer) would be willing to pay, rather than go without the thing, over what he actually does pay. On the basis of this definition, we can say that a consumer is, ordinarily, willing to pay more than what he actually pays and this difference is his consumer's surplus. This amount of consumer's surplus can be derived with the help of marginal and total utilities. Suppose the MU of a commodity is as given in the previous table -1.1 and the price is$8. Under this situation the consumer's surplus can be calculated as follows.

Table -1.1

(Calculation of Consumer's Surplus)

 Units of Consumption Marginal              Utility  ($) Price Consumer's Surplus 1 15 8 7 2 14 8 6 3 11 8 3 4 10 8 2 5 8 8 0 Total 58 40 18 In this table we find that for the first unit the MU is$15 or the consumer is willing to pay $15 for the first unit whereas he actually pays only$8. Thus, the consumer's surplus derived by him froin the first unit of consumption is 7. Similarly from the second unit he derives a surplus of 6 and so on. From the last unit of consumption, he does not obviously derive any surplus since the MU Price. Hence, his total consumer's surplus for 5 units of consumption is

7 + 6 + 3 + 2 + 0 = $18. This consumer's surplus can also be explained in terms of total utility and price paid. We see that the total utility derived by he consumer is$58 (Summation of marginal utilities) and the total price paid is $40 (8~5). Hence, the consumer's surplus is$58 - 40 = $18. This is the same as we get from the summation of the surplus derived by each individual unit. In this way, we find that the maximum price which a consumer is willing to pay is equal to the total utility derived from that commodity but he actually pays a lower sum. This difference is his consumer's surplus. On the basis of the above analysis, we can also derive the consumer's surplus at a price of$11, $10,$7 which shall be $7,$10, \$.23 respectively. Thus, we find that a decrease in price, increase the consumer's surplus and an increase in price reduces it.

The Law of diminishing marginal utility, helps us understand the behaviour of the consumer and we can also find the consumer's equilibrium with the help of this concept.