Concept of Consumer Plus

The demand curve is a graphic representation used to calculate consumer surplus. It

shows the relationship between the price of a product and the quantity of the product
demanded at that price, with price drawn on the y-axis of the graph and quantity
demanded drawn on the x-axis. Because of the law of diminishing marginal utility,
the demand curve is downward sloping.

Consumer surplus is measured as the area below the downward-sloping demand

curve, or the amount a consumer is willing to spend for given quantities of a good,
and above the actual market price of the good, depicted with a horizontal line drawn
between the y-axis and demand curve. Consumer surplus can be calculated on
either an individual or aggregate basis, depending on if the demand curve is
individual or aggregated. Consumer surplus always increases as the price of a good
falls and decreases as the price of a good rises.

To illustrate, suppose an individual or economy is willing to pay $50 for the first unit
of product A and $20 for the 50th unit. If 50 of the units are sold at $20 each, then 49
of the units were sold at a consumer surplus, assuming the demand curve is
constant. Consumer surplus is depicted as the triangle that forms between the
following points on a graph: (0,50), (0,20) and (50,20). The numerical value is
calculated as half, or 0.50, multiplied by the base of the triangle multiplied by the
height of the triangle, or 0.50*30*50.

What is 'Producer Surplus'

Producer surplus is an economic measure of the difference between the amount a

producer of a good receives and the minimum amount the producer is willing to
accept for the good. The difference, or surplus amount, is the benefit the producer
receives for selling the good in the market. Producer surplus is generated by market
prices in excess of the lowest price producers would otherwise be willing to accept
for their goods.
Example of Producer Surplus

Say a producer is willing to sell 500 widgets at $5 each and consumers are willing to
purchase these widgets for $8 each. If the producer sells all of the widgets to
consumers for $8, it receives $4,000. To calculate the producer surplus, subtract the
amount the producer received by the minimal amount it was willing to accept, in this
case $2,500. The producer surplus is $1,500, or $4,000 - $2,500. It is not static and
may increase or decrease as the market price increases or decreases.

Impact on Producer Surplus

Producers would not sell products if they could not get at least the marginal cost to
produce those products. As such, producer surplus is the difference between the
price received for a product and the marginal cost to produce it. From an economics
standpoint, marginal cost includes opportunity cost. In essence, opportunity cost is
the cost of not doing something different such as producing a different item.

Ordinal Approach to Consumer Behaviour

Modern economists disregarded the concept of ‘cardinal measure of utility’. They

were of the opinion that utility is a psychological phenomenon and it is next to
impossible to measure the utility in absolute terms. According to them, a consumer
can rank various combinations of goods and services in order of his preference. For
example, if a consumer consumes two goods, Apples and Bananas, then he can
indicate:

1. Whether he prefers apple over banana; or

2. Whether he prefers banana over apple; or

3. Whether he is indifferent between apples and bananas, i.e. both are equally
preferable and both of them give him same level of satisfaction.

This approach does not use cardinal values like 1, 2, 3, 4, etc. Rather, it makes use
of ordinal numbers like 1st, 2nd, 3rd, 4th, etc. which can be used only for ranking. It
means, if the consumer likes apple more than banana, then he will give 1st rank to
apple and 2nd rank to banana. Such a method of ranking the preferences is known as
‘ordinal utility approach’.

Before we proceed to determine the consumer’s equilibrium through this approach,

let us understand some useful concepts related to Indifference Curve Analysis.

Assumptions of Indifference Curve

The various assumptions of indifference curve are:

1. Two commodities:

It is assumed that the consumer has a fixed amount of money, whole of which is to
be spent on the two goods, given constant prices of both the goods.

2. Non Satiety:

It is assumed that the consumer has not reached the point of saturation.
Consumer always prefer more of both commodities, i.e. he always tries to move to a
higher indifference curve to get higher and higher satisfaction.

3. Ordinal Utility:

Consumer can rank his preferences on the basis of the satisfaction from each
bundle of goods.

4. Diminishing marginal rate of substitution:

Indifference curve analysis assumes diminishing marginal rate of substitution. Due to

this assumption, an indifference curve is convex to the origin.

5. Rational Consumer:

The consumer is assumed to behave in a rational manner, i.e. he aims to maximize

his total satisfaction.

Meaning of Indifference Curve:

When a consumer consumes various goods and services, then there are some
combinations, which give him exactly the same total satisfaction. The graphical
representation of such combinations is termed as indifference curve.
Indifference curve refers to the graphical representation of various alternative
combinations of bundles of two goods among which the consumer is indifferent.
Alternately, indifference curve is a locus of points that show such combinations of
two commodities which give the consumer same satisfaction. Let us understand this
with the help of following indifference schedule, which shows all the combinations
giving equal satisfaction to the consumer.

Table 2.5: Indifference Schedule

Combination
Apples Bananas
of Apples
and Bananas (A) (B)
P 1 15
Q 2 10
R 3 6
S 4 3
T 5 1

As seen in the schedule, consumer is indifferent between five combinations of apple

and banana. Combination ‘P’ (1A + 15B) gives the same utility as (2A + 10B), (3A +
6B) and so on. When these combinations are represented graphically and joined
together, we get an indifference curve.

Let apples are measured along the X-axis and bananas on the Y-axis. All points
(P, Q, R, S and T) on the curve show different combinations of apples and bananas.
These points are joined with the help of a smooth curve, known as indifference curve
(IC1). An indifference curve is the locus of all the points, representing different
combinations, that are equally satisfactory to the consumer.

Every point on IC1, represents an equal amount of satisfaction to the consumer. So,
the consumer is said to be indifferent between the combinations located on
Indifference Curve ‘IC1’. The combinations P, Q, R, S and T give equal satisfaction to
the consumer and therefore he is indifferent among them. These combinations are
together known as ‘Indifference Set’.

Monotonic Preferences:

Monotonic preference means that a rational consumer always prefers more of a

commodity as it offers him a higher level of satisfaction. In simple words, monotonic
preferences imply that as consumption increases total utility also increases. For
instance, a consumer’s preferences are monotonic only when between any two
bundles, he prefers the bundle which has more of at least one of the goods and no
less of the other good as compared to the other bundle.

Example: Consider 2 goods:

Apples (A) and Bananas (B).

(a) Suppose two different bundles are: 1st: (10A, 10B); and 2nd: (7A, 7B).

Consumer’s preference of 1st bundle as compared to 2nd bundle will be called

monotonic preference as 1st bundle contains more of both apples and bananas.

(b) If 2 bundles are: 1st: (10A, 7B); 2nd: (9A, 7B).

Consumer’s preference of 1st bundle as compared to 2nd bundle will be called

monotonic preference as 1st bundle contains more of apples, although bananas are
same.

Indifference Map:

Indifference Map refers to the family of indifference curves that represent consumer
preferences over all the bundles of the two goods. An indifference curve represents
all the combinations, which provide same level of satisfaction. However, every higher
or lower level of satisfaction can be shown on different indifference curves. It means,
infinite number of indifference curves can be drawn.

Properties of Indifference Curve:

1. Indifference curves are always convex to the origin:

An indifference curve is convex to the origin because of diminishing MRS. MRS
declines continuously because of the law of diminishing marginal utility. When the
consumer consumes more and more of apples, his marginal utility from apples keeps
on declining and he is willing to give up less and less of bananas for each apple.
Therefore, indifference curves are convex to the origin. It must be noted that MRS
indicates the slope of indifference curve.

2. Indifference curve slope downwards:

It implies that as a consumer consumes more of one good, he must consume less of
the other good. It happens because if the consumer decides to have more units of
one good (say apples), he will have to reduce the number of units of another good
(say bananas), so that total utility remains the same.

3. Higher Indifference curves represent higher levels of satisfaction:

Higher indifference curve represents large bundle of goods, which means more utility
because of monotonic preference.

4. Indifference curves can never intersect each other:

As two indifference curves cannot represent the same level of satisfaction, they
cannot intersect each other. It means, only one indifference curve will pass through a
given point on an indifference map.

Income–consumption curve

In economics and particularly in consumer choice theory, the income-consumption

curve is a curve in a graph in which the quantities of two goods are plotted on the
two axes; the curve is the locus of points showing the consumption bundles chosen
at each of various levels of income.

The income effect in economics can be defined as the change in consumption

resulting from a change in real income. This income change can come from one of
two sources: from external sources or from income being freed up (or soaked up) by
a decrease (or increase) in the price of a good that money is being spent on. The
effect of the former type of change in available income is depicted by the income-
consumption curve discussed in the remainder of this article, while the effect of the
freeing-up of existing income by a price drop is discussed along with its companion
effect, the substitution effect.

The consumer's preferences, monetary income and prices play an important role in
solving the consumer's optimization problem (choosing how much of various goods
to consume so as to maximize their utility subject to a budget constraint).
The comparative statics of consumer behaviour investigates the effects of changes
in the exogenous or independent variables (especially prices and money incomes of
the consumers) on the chosen values of the endogenous or dependent variables
(the consumer's demands for the goods). When the income of the consumer rises
with the prices held constant, the optimal bundle chosen by the consumer changes
as the feasible set available to him changes. The income–consumption curve is
the set of tangency points of indifference curves with the various budget constraint
lines, with prices held constant, as income increases shifting the budget constraint
out.
The income effect is a phenomenon observed through changes in purchasing
power. It reveals the change in quantity demanded brought by a change in real
income. The above figure on the left shows the consumption patterns of the
consumer of two goods X1 and X2, the prices of which are p1and p2 respectively. The
initial bundle X*, is the bundle which is chosen by the consumer on the budget line
B1. An increase in the money income of the consumer, with p1 and p2 constant, will
shift the budget line outward parallel to itself.

In the figure, this means that the change in the money income of the consumer will
shift the budget line B1 outward parallel to itself to B2 where the bundle X' bundle will
be chosen. Again, an increase in the money income of the consumer will push the
budget line B2 outward parallel to itself to B3 where the bundle X" will be the bundle
which will be chosen. Thus, it can be said that, with variations in income of the
consumers and with the prices held constant the income–consumption curve can
be traced out as the set of optimal points.

Income–consumption curve for different goods

 Income-consumption curve for Normal goods

 Inferior Goods
With an increase in the income of demand for normal good X2 rises while, demand
for inferior good X1 falls.

Income–consumption curve for perfect substitutes

Income–consumption curve for perfect complements