Hypothesis of Utility Maximization: Consumer Equilibrium
A consumer faces constraint in the form of limited money income. In order to maximize satisfaction, he allocates his limited income among various goods in such a way that MU of each good is proportional to its price. That is, he takes into account the marginal utilities of goods and prices of goods to achieve equilibrium. We also know that, the MU derived from consuming various goods is subject to diminishing returns and some goods yield greater satisfaction than others. As a rational consumer, an individual selects a good with highest utility followed by others in succession. He switches his expenditure from one good to the other in accordance with their MU.
The utility maximizing consumer attains equilibrium when he spends his income in such a way that the utility derived from the last rupee spent on each good is' equal. Suppose there are two goods X and Y. The consumer will exchange his money income for good X as long as MU of good X is greater than constant utility of money weighted by the price of the good. That is, the consumer will get more utility by increasing expenditure and the level of satisfaction is where;
MUX=PX(MUm) or MUm = MUx/Px
where MUm is marginal utility of money expenditure, MUx is the marginal utility of good, X and P x is the price of good X. Since the law of equi-marginal utility states that a consumer will spend his money income on various goods in such a way that marginal utility of each good is proportional to its price. The consumer will spend his money income on purchase of X and Y such that,
MUx/Px = MUy/Py
The equation shows that a consumer reaches equilibrium when the marginal utility derived from each rupee spent on X and Y is the same. The equality is achieved at different points of expenditure. The total money income defines the point where the consumer will fix his expenditure.
MUm =MUx/Px = MUy/Py
The above equation applies in case of more than two goods as well.
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