EQUILIBRIUM OF THE CONSUMER

If we assume that consumers (households) generally try to maximize the utility (or satisfac-tion) they get by spending their incomes, two im-portant propositions follow.

First, each consumer will change the pattern of goods and services he buys whenever he can get more utility by spending an extra dollar on item A rather than on item B. He will maximize his total utility when he allocates his income so that the marginal utility he receives from the last dollar spent on each item he buys is identical. When he so allocates his income, the consumer is “in equilibrium,” in the sense that he is maximizing the satisfaction he can obtain by spending his income. He has no incentive to change to another spending pattern.

This is only common sense. If the consumer can get a larger marginal utility by spending a dollar on A than B, obviously he will spend it on A. ‘Whenever the marginal utility of the last dollar spent on different commodities is unequal, he can increase his total utility by switching from the lower to the higher marginal utility commodities. If, to simplify, we assume that the price of every commodity is the same, he will so allocate his income as to obtain the same marginal utility from every commodity he buys. We could write this in equation form as follows: MU~ = MU~ MtJZ, etc., where x, y, and z are the commodities bought.

If the prices of different commodities vary, as they do in actual life, the consumer in equilibrium would not expect to get the same marginal utility from each commodity, but only from the last dollar spent on each commodity. It would be nonsense to think of so allocating your income as to obtain the same marginal utility from a movie and an automobile. But if we divide the marginal utility from each by the price of each, then we have made them comparable. Then we can state our central proposition again: For the consumer to be in equilibrium, the marginal utility of the last dollar spent on each commodity must be equal. In equation form, the equilibrium condition is, therefore: where P is the price of each commodity.

We can extend this reasoning to other uses of households’ incomes. Clearly each household has another alternative—we may save part of our disposable income rather than spending it. To be in equilibrium, we must so allocate our incomes between saving and spending that the marginal utility obtained from a dollar saved is equal to that obtained from a dollar spent on each item we buy. Equating marginal utilities works for all uses of the dollars we have to spend or save.

When consumers spend their incomes this way, their demand curves for different products accurately reflect the relative marginal utilities they think they will obtain from different products they might buy. If A spends a dollar for a necktie rather than for a movie ticket, we can safely assume he prefers the tie to the movie. His preferences are reflected in his demand curves for the two products, and his demands will reflect to producers the relative values he places on neckties and movies.

This is an extremely important point, since in our system we rely largely on consumer demand to give signals to producers on what should be produced and in what quantities. If the system is to perform efficiently, it should allocate re~ sources in accordance with these consumer demands. This test will be applied to different types of markets and economies in later chapters.

Some Applications

Consider three simple applications of this reasoning that consumers will always tend to move toward an equilibrium condition. First, suppose that all consumers are in equilibrium, as described above. Now consumers’ tastes change and they desire more beefsteak relative to pork chops. At existing prices, consumers are now out of equilibrium, and they will switch their purchases from pork chops to steak. This increase in consumer demand for steak will both push up the price of steak and signal farmers to produce more beef, while the reverse action occurs for pork. A new consumer equilibrium will be reached when, at the new prices for beef and pork, the marginal utilities obtainable from a dollar spent on each are again equal.

A second application: Begin again with consumers in equilibrium, and now assume that a disastrous drought in Latin America drastically reduces the world’s coffee supply. This will raise the price of coffee relative to the price of tea and other drinks. At the new price ratios, consumers will be out of equilibrium and will switch from buying coffee to buying more tea, until at the new relative prices the marginal utilities obtained from spending a dollar on each are roughly the same. Changes in relative prices have signaled changes in the relative costs of supplying coffee and tea, and consumers have changed their purchases of the two to re-establish a situation in which they maximize the utility obtainable from the incomes they have to spend.

FIG. 20-4 The consumer poys only 50 cents (yellow
rectangle) for his 5 bananas, but his demond curve shows
he would hove been willing to poy more thon 10 cents for
eoch of the first 4. Thus the red triongle meosures how
much more he would hove been willing to pay to get the
total utility provided by 5 bananas, and hence measures
the “consumer’s surplus” he obtains free.

A third application: When a consumer is in equilibrium he is usually receiving a “consumer surplus” on the commodities he buys. Figure 20-4 shows a typical downward-sloping consumer demand curve, say for bananas. The market price is 10 cents per banana, and this consumer buys five per week. But his demand curve shows he would have been willing to pay 20 cents for the first banana, 17 cents for the second, and so on. He gets a “consumer’s surplus” of utility on each of the first four bananas, since he has to pay only 10 cents for each. The shaded area provides a measure of this consumer’s surplus, if in fact the demand curve accurately reflects the marginal utility of each additional banana to this consumer. (Thought teaser: How much consumer’s surplus do you get on each gallon of water you drink? On each cubic foot of air you breathe?)