Ordinal Utility Approach

1. Indifference
Curve
Analysis
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2. Ordinal Utility Approach
Ordinal Utility Approach:
The basic idea behind ordinal utility approach is that a
consumer keeps number of pairs of two commodities in
his mind which give him equal level of satisfaction.
This means that the utility can be ranked qualitatively.
The ordinal utility approach differs from the cardinal
utility approach (also called classical theory) in the
sense that the satisfaction derived from various
commodities cannot be measured objectively.
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3. Ordinal theory is also known as neo-classical theory of
consumer equilibrium, Hicksian theory of consumer
behavior, indifference curve theory, optimal choice
theory. This approach also explains the consumer's
equilibrium who is confronted with the multiple
objectives and scarcity of money income.
The important tools of ordinal utility are:
1. The concept of indifference curves.
2. The slop of I.C. i.e. marginal rate of substitution.
3. The budget line.
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4. Indifference Curve
Indifference Curve is a locus of all such points
which shows different combination of two
commodities which yield equal satisfaction to the
consumer, so that he is indifferent to the particular
combination he consumes.
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5. Indifference Curve schedule
It refers to a schedule that indicates different
combinations of two commodities which yield equal
satisfaction. table 1. indifference curve schedule
Combinationof
apples andoranges
Apples Oranges
A 1 10
B 2 7
C 3 5
D 4 4
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6. Indifference Curve
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7. Indifference Map
refers to a set of
Indifference Curve.
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8. Assumptions of
Indifference Curve Analysis:
a) Consumer is rational.
b) Utility can be measured in Ordinal numbers.
c) Marginal rate of substitution (MRS) diminishes
(marginal rate of substitution is the rate at which a
consumer is ready to give up one good in exchange
for another good while maintaining the same level of
utility)
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9. d) Consumer’s behavior is Consistent.
E.g. if consumer prefers A combination > B combination
at one time, then at another time he will not prefer
more of B combination than A combination.
e) Transitivity.
E.g. if consumer prefers A combination to B
combination and B combination to C combination, then
he will definitely prefer A combination to C
combination.
f) Consumer’s scale of Preference is Independent of his
income and prices of goods in the market.
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10. Rambabu Sambattina

11. 1) Straight line
indifference curve :
In case of Perfect
Substitutes, IC may be a
straight line with negative
slope.
e.g. Taj Mahal (X-
commodity) and Brooke
Bond tea (Y-commodity)
are perfect substitute of
each other.
Here,
MRSxy = 1
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12. 2)Right-angled Indifference
Curve :
In case of Perfectly
Complementary goods, the
shape of IC is right-Angle.
e.g. a consumer will buy right
and left shoes in a fixed
ratio.
Here,
MRSxy = 0
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13. Rambabu Sambattina

14. The Budget line shows all different combinations of
the two commodities that a consumer can purchase
given his money income and price of two commodities.
Slope of Price line = Px/Py
Here;
Px= price of apples
Py = price of oranges
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15. Suppose ; a consumer has:
Income = Rs. 4 to be spent on apples and oranges.
Price of apple = Rs. 1.00
Price of oranges = Rs. 0.50
the different combinations that a consumer can get of these goods are :
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16. From Figure;
Budget line = AB
 If there is any point outside
or to the right of price line
AB, the consumer will not be
able to buy that combination
of two goods because of his
limited income.
 If there is any point inside or
to the left of price line AB,
then the consumer will be
unable to spend all his income.
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17. Change in
Income
Effect on
Price Line
Rise Shift to Right
Fall Shift to Left
1) Due to change in
Income:
Assumptions :
o price of two goods
remain constant and
o income of consumer
changes.
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18. 2) Due to change in the
Price of one
commodity:
Assumptions:
 Income of consumer
remain unchanged.
 Price of one commodity is
constant.
 Price of other commodity
changes.
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20. Consumer’s equilibrium refers to a situation in
which a consumer with given income and given
prices purchases such a combination of goods and
services which gives him maximum satisfaction
and he is not willing to make any change in it.
It is struck when
“what he is willing to buy coincides with what
he can buy”
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21.  Prices of goods are constant.
 Consumer’s income is also constant.
 Consumer knows the prices of all things.
 Consumer can spend his income in small quantities.
 Consumer is rational.
 Consumer is fully aware of Indifference map.
 Perfect competition in the market.
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22. 1) Price line should be tangent to Indifference Curve.
or
Slope of IC = Slope of Price line
or
MRSxy = Px/Py
2) Indifference Curve must be Convex to the Origin.
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23. When the consumer is in
equilibrium, his highest
attainable Indifference
Curve is tangent to price
line.
From Figure:
At point ‘D’, slope of
Indifference Curve and Price
Line coincide. Therefore, first
condition of consumer’s
equilibrium is satisfied.
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24. It means that MRS of
Apples for Oranges should
be diminishing.
If at the point of
equilibrium, Indifference
Curve is Concave and not
Convex to the Origin, then
it will not be a position of
permanent equilibrium.
Therefore, a consumer will
be in permanent equilibrium
where both the conditions
are satisfied.
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25. IT IS THE RATE A T WHICH THE CONSUMER IS WILLING
TO GIV E UP COMMODITY Y FOR ONE MORE UNIT OF
COMMODITY X IN ORDER TO MAINTAIN THE SAME
LEVEL OF SATISFACTION.
UTILITY GAINED OF GOOD X=UTILITY LOST OF GOOD Y
IT IS ESTIMATED AS
MRSXY = ΔY/ΔX
ON ANY POINT ON IC.
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26. According to this Law, “ as a consumer gets
more and more units of X , he will be willing
to give up less and less units of Y”
In other words, the marginal rate of
substitution of X for Y will go on diminishing
while the level of satisfaction of the consumer
remains the sameRambabu Sambattina

27. Combina
tions
Apples
(X)
Oranges
(Y)
MRS =
Loss Y/
Gain X
A 1 10 _
B 2 7 3/1
C 3 5 2/1
D 4 4 1/1
Table 2. Schedule
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28. Table 2. indicates that the consumer will give up
 3 oranges for getting the second apple,
 2 oranges for getting the third apple and
 1 orange for getting the fourth apple.
In other words, MRS of apples for oranges goes
on diminishing.
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29. ?
It diminishes ;
 As Law of Diminishing marginal rate of substitution is an extensive
form of Law of diminishing marginal utility.
 According to Law of Diminishing Marginal Utility,
 Consequently, consumer is willing to give up less and less units of
oranges for every additional unit of apple.
 Therefore, Marginal rate of substitution of apples for oranges
diminishes.
As Consumption by
Consumer
Marginal Utility goes on
1) Increases 1) Diminishing
2) Decreases 2) Increasing
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30. The marginal rate of substitution is constant
if to obtain one more unit of X, only one
unit of Y is sacrificed to maintain same level
of satisfaction. Marginal rate of
substitution of perfect substitution is
constant. TABLE 3.
Combination Apples Oranges MRS=
Loss Y/Gain X
A 1 10 _
B 2 9 1/1
C 3 8 1/1
D 4 7 1/1
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31. Indifference
Curve will be a
Straight line
falling downwards
from left to right.
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32. It implies that as the stock of a commodity increases with
the consumer he substitutes it for the other commodity at
an increasing rate to maintain the same level of
satisfaction.
Table 4.
Combinations Apples Oranges MRS=
Loss Y/Gain X
A 1 10 _
B 2 9 1/1
C 3 7 2/1
D 4 4 3/1
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33. Indifference
Curve will be
Concave to the
point of origin.
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34. Type of
goods
Price effect Income
effect
Shape of
Demand
Curve
1) Normal
Goods
Negative Positive Slopes
Upward
2) Inferior
Goods
Negative Negative Slopes
Downward
3) Giffen’s
Goods
Positive Negative Slopes
Upward
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35. Basis of
Difference
Law of Diminishing
Marginal Utility
Law of Diminishing
Marginal Rate of
Substitution
1) Measurement in
Cardinal/Ordina
l numbers
Unrealistic assumption
that marginal utility can
be measured in Cardinal
numbers.
Realistic assumption that
utility can be measured in
Ordinal numbers.
2) Independence
of Commodities
Utility of one commodity
is independent of the
utility of other
commodity.
Utility of one commodity
is dependent of the utility
of other commodity.
3) Marginal utility
of money (MUm)
Assumption is that MUm
remains constant.
No such assumption.
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