ORDINAL UTILITY

According to this indifference curve analysis, the utility cannot be measured precisely but the
consumer can state which of the two combinations of goods he prefers without describing the
magnitude of strength of his preference. This means that if the consumer is presented with a
number of various combinations of goods, he can order or rank them in a ‘scale of
preferences’. If the various combinations are marked A, B, C, D, E etc., the consumer can tell
whether he prefers A to B, or B to A or is indifferent between them. Similarly, he can
indicate his preference or indifference between any other pairs or combinations. The concept
of ordinal utility implies that the consumer cannot go beyond stating his preference or
indifference. In other words, if a consumer prefers A to B, he can not tell by ‘how much’ he
prefers A to B. The consumer cannot state the ‘quantitative differences’ between various
levels of satisfaction; he can simply compare them ‘qualitatively’, that is, he can merely
judge whether one level of satisfaction is higher than, lower than or equal to another.

Economists following the lead of Hicks, Slutsky and Pareto believe that utility is measurable
in an ordinal sense

The important tools of ordinal utility are:

– The concept of indifference curves.

– The slope of I.C. i.e. marginal rate of substitution.

– The budget line.

INDIFFERENCE ANALYSIS

Meaning of indifference curve & definition

The indifference curve indicates the various combinations of two goods which yield equal
satisfaction to the consumer. By definition:
•"An indifference curve shows all the various combinations of two goods that give an equal
amount of satisfaction to a consumer".
• An indifference curve is the locus of all commodity bundles (combinations) that give the
consumer the same level of utility (ie, the consumer is indifferent between these bundles.

Commodity Y

Commodity X

1
Indifference Schedule
Example One
Suppose that each of the bundles A, B, C, and D as defined in the following table will give
Mary 100 units of satisfaction in other words, Mary is indifferent among them then the graph
of quantity of chocolate against quantity of peanut butter is called an indifference curve

Bundle/combination Quantity of Quantity of Utility

Peanut/X Chocolate/Y

A L 10 1 1 9 100
B M 6 2 2 6 100
C N 3 3 3 4 100
D O 1 4 4 3 100

It merely indicates a set of consumption bundles that the consumer views as being equally
satisfactory.

Every point on indifference curve represents a different combination of the two goods and the
consumer is indifferent between any two points on the indifference curve. All the
combinations are equally desirable to the consumer. The consumer is indifferent as to which
combination he receives. The Indifference Curve IC thus is a locus of different combinations
of two goods which yield the same level of satisfaction.

Assumptions
The ordinal utility theory or the indifference curve analysis is based on following main
assumptions:
1. Rational behaviour of the consumer: It is assumed that individuals are rational in
making decisions from their expenditures on consumer goods.

2. Utility is ordinal: Utility cannot be measured cardinally. It can be, however,

expressed ordinally. In other words, the consumer can rank the basket of goods
according to the satisfaction or utility of each basket.

3. Diminishing marginal rate of substitution: In the indifference curve analysis, the

principle of diminishing marginal rate of substitution is assumed.

4. Consistency in choice: The consumer, it is assumed, is consistent in his behaviour

during a period of time.
For insistence, if the consumer prefers combinations of A over B, then he can’t
change his preference to B over A. The behaviour should be remains consistent in
another period.

2
5. Transitivity of choice: Consumer’s choices are assumed to be transitive. Which
means that if consumer prefer A to B, B to C then he can prefer A to C.
OR
In other word if consumer treats A=B, B=C then he treat A=C too.

6. Goods consumed are substitutable: The goods consumed by the consumer are
substitutable. The utility can be maintained at the same level by consuming more of
some goods and less of the other. There are many combinations of the two
commodities which are equally preferred by a consumer and he is indifferent as to
which of the two he receives.

7. Non-satiety: It implies that consumer has not reached the point of saturation in the
consumption of any good. Thus, he tries to move to higher IC to get higher
satisfaction.

8. Independent Scale of Preference: It means if the income of the consumer changes

or prices of goods fall or rise in the market, these changes will have no effect on the
scale of preference of the consumer. It is further assumed that scale of preference of a
consumer is not influenced by the scale of preference of another consumer.

Properties/Characteristics of Indifference Curve

1. Indifference Curves are Negatively Sloped: The indifference curves must slope
down from left to right. This means that an indifference curve is negatively sloped. It
slopes downward because as the consumer increases the consumption of X
commodity, he has to give up certain units of Y commodity in order to maintain the
same level of satisfaction

2. Higher Indifference Curve Represents Higher Level of satisfaction: A higher

indifference curve that lies above and to the right of another indifference curve
represents a higher level of satisfaction and combination on a lower indifference curve
yields a lower satisfaction.

3
 3. Indifference Curve are Convex to the Origin: his is equivalent to saying that as the
consumer substitutes commodity X for commodity Y, the marginal rate of substitution
diminishes of X for Y along an indifference curve

4. Indifference Curve Cannot Intersect Each Other: This cannot be possible because
as the level of satisfaction of two indifference curve is different and because of that
both curve cannot intersect each other.

5. Indifference Curves do not Touch the Horizontal or Vertical Axis: One of the
basic assumptions of indifference curves is that the consumer purchases combinations
of different commodities. He is not supposed to purchase only one commodity. In that
case indifference curve will touch one axis. This violates the basic assumption of
indifference curves.

This type of Indifference curve should not be there because consumer has to purchase atleast
one unit the commodity of both the commodity.

4
Criticism of Indifference Curve Approach:

Robertson, Armstrong, Knight etc. have criticised indifference curve analysis on account of
the following.
1. Unrealistic assumption: Indifference curve analysis is based on the assumption that a
consumer has complete knowledge regarding the preference of two goods. In reality, he
cannot take quick decisions in real life in respect of different combinations.
2. Complex analysis: Indifference curve analysis can explain easily that behaviour of the
consumer which is restricted to the combination of only two goods. If the consumer wants
combinations of more than two goods, then indifference curve analysis becomes highly
complex.
3. Imaginary: Indifference curve analysis is based on imaginary combinations. A consumer
does not decide always demand for the same combinations of two goods.

4. Assumption of Convexity: This theory does not explain why an indifference curve is
convex to the point of origin. In real life, it is not necessary that all goods should have
diminishing marginal rate of substitution. There is also the concept of concave also incase of
Inferior Goods.

5. Unrealistic combinations: When we consider different Combinations of two goods,

sometimes we come across such funny combinations that have no meaning for the consumer.
For instance, there is a combination of 10 shirts + 2 pairs of shoes. If in the subsequent
combinations shirts are given up to get more pairs of shoes then we way arrive at a
combination representing 2 shirts + 10 pairs of shoes, which is not correct at all.

6. Impractical: Indifference curve analysis is based on the unrealistic assumption that goods
are homogenous. ‘This assumption holds good only under perfect competition, which is more
theoretical concept. In real life, monopolistic and oligopolistic conditions are found more
prevalent.

An Indifference Map:
A graph showing a whole set of indifference curves is called an indifference map. An
indifference map, in other words, is comprised of a set of indifference curves. Each
successive curve further from the original curve indicates a higher level of total satisfaction.

5
Marginal Rate of Substitution (MRS):

The concept of marginal rate substitution (MRS) was introduced by Dr. J.R. Hicks and Prof.
R.G.D. Allen to take the place of the concept of diminishing marginal utility. Allen and Hicks
are of the opinion that it is unnecessary to measure the utility of a commodity. The necessity
is to study the behavior of the consumer as to how he prefers one commodity to another and
maintains the same level of satisfaction.

The rate or ratio at which goods X and Y are to be exchanged is known as the marginal rate
of substitution (MRS).
In the words of Hicks: “The marginal rate of substitution of X for Y measures the number of
units of Y that must be scarified for unit of X gained so as to maintain a constant level of
satisfaction”.
Marginal rate of substitution (MRS) can also be defined as: “The ratio of exchange between
small units of two commodities, which are equally valued or preferred by a consumer”.

Formula:

MRSxy= ∆Y/∆X = Change in Y/ Change in X=Loss of Y/ Gain of X

MRSyx= ∆X/∆Y = Change in X/ Change in Y =Loss of X/ Gain of Y

The concept of MRS can be easily explained with the help of schedule given below:
Bundle/combination Quantity of Quantity of MRS of X for Y
Peanut/X Chocolate/Y

1 1 13 -
2 2 9 4:1
3 3 6 3:1
4 4 4 2:1
5 5 3 1:1

6
In the table given above, all the five combinations of good X and good Y give the same
satisfaction to the consumer. If he chooses first combination, he gets 1 unit of good X and 13
units of good Y. In the second combination, he gets one more unit of good X and is prepared
to give 4 units of good Y for it to maintain the same level of satisfaction. The MRS is
therefore, 4:1. In the third combination, the consumer is willing to sacrifice only 3units of
good Y for getting another unit of good X. The MRS is 3:1.Likewise, when the consumer
moves from 4thto 5thcombination, the MRS of good X for good Y falls to one (1:1). This
illustrates the diminishing marginal rate of substitution. This behavior showing falling
MRS of good X for good Y and yet to remain at the same level of satisfaction is known as
diminishing marginal rate of substitution.

DMRS states diminishing quantities of one good must be sacrificed to obtain successive
equal increases in the quantity of the other good.

An indifference curve exhibits a diminishing marginal rate of substitution:

1. The more of good x you have, the more you are willing to give up to get a little of
good y.
2. The indifference curves
• Get flatter as we move out along the horizontal axis
• Get steeper as we move up along the vertical axis.

Importance of Marginal Rate of Substitution (MRS):

(i) Measures utility ordinally: The concept of MRS is superior to that of utility concept
because it is more realistic and scientific than the theory of utility. It does not measure the
utility of a commodity in isolation without reference to other commodities but takes into
consideration the combination of related goods to which a consumer is interested to purchase.
(ii) A relative concept: The concept of marginal rate of substitution has the advantage that it
is relative and not absolute like the utility concept given by Marshall. It is free from any
assumptions concerning the possibility of a quantitative measurement of utility

Budget line or Price line

A budget line or price line represents the various combinations of two goods which can be
purchased with a given money income and assumed prices of goods

It is also known as Price Opportunity line or Budget Constraint line. C

Budget line is drawn as a continuous line. It identifies the options from which the consumer
can choose the combination of goods. Budget line (BL) or consumption possibility curve or
line of attainable combinations is a boundary showing the largest possible combinations of

7
goods that a consumer can buy in a market, given his money income and market prices of the
goods.

Budget line Equation:

M=PxQx + PyQy

M = Money income

Qx = Quantity of commodity X consumed

Qy = Quantity of commodity Y consumed

Px = Price of commodity X

Py = Price of commodity Y

Slope of Budget Line:

The slope of Budget line is the ratio of prices of two commodities and it is symbolically
expressed as:

Slope of BL = Px/Py

Characteristics of Budget Line

1. The shape of the budget line depends on the income of the consumer and the prices of
the two goods
2. It is always a straight line.
3. It has a negative slope downwards from left to right
4. The slope of PL is equal to the ratio of the prices of the two goods
5. The position of price line is determined by the size of income of the consumer & its
slope is shaped by the price structure of two commodities.

8
Changes in Prices

Keeping the income of the consumer constant, when the price of any one good changes and
the price of the other good remains the same, the slope of the budget line changes.

a. If the price of one good rises when the prices of other goods and the budget
(income) remain the same, consumption possibilities shrink.

b. If the price of one good falls when the prices of other goods and the budget
(income) remain the same, consumption possibilities expand.

1. When the price of X changes

If the price of X rises then AB2 will be the price-line while if the price of X falls then AB1 will
be the price-line.

2. When the price of Y changes

9
If the price of Y rises then B2L will be the price-line while if the price of X falls then B1L will
be the price-line.

3. When the price of both commodities change

Commodity Y P

P1

L L1

i) When the price of X falls and price of Y rises (shown above)

ii) When the price of X rises and price of Y falls (shown below)

Commodity Y P1

L1 L

Commodity X

Change in the Income of the consumer

 Keeping the prices of two commodities constant, when a consumer’s income

increases, consumption possibilities expand.
 Keeping the prices of two commodities constant, when a consumer’s income
decreases, consumption possibilities shrink.
 A decrease in the income shifts the budget line leftward ( P2L2) while the slope of the
budget line doesn’t change because prices have not changed.
 An increase in the income shifts the budget line rightward ( P1L1) while the slope of
the budget line doesn’t change because prices have not change.

10
 P1

Commodity Y P2

L2 L L1

Commodity X

Consumer Equilibrium under Indifference Curve Analysis

"A consumer is said to be in equilibrium at a point where the price line is touching the
highest attainable indifference curve from below"

"The term consumer’s equilibrium refers to the amount of goods and services which the
consumer may buy in the market given his income and given prices of goods in the market,
that give maximum satisfaction to consumer". The aim of the consumer is to get maximum
satisfaction from his money income, given the price line or budget line and the indifference
map.

Assumptions of Consumer’s Equilibrium

1. The consumer has Indifference Map of good X and Good Y

2. The consumer have a fixed money income which are spend on X and Y

3. The Prices of good X –Px and good Y – Py are given

4. Good are homogenous

5. Goods are divisible

6. The consumer acts rationally and tries to maximise his satisfaction.

7. No change in tastes and habits of consumer

8. Perfect competition.

Conditions of Consumer’s Equilibrium under Indifference Curve Analysis

First order condition : Necessary Condition

11
Budget Line Should be Tangent to the Indifference Curve: A given price line should be
tangent to an indifference curve or marginal rate of substitution of good X for good Y
(MRSxy=∆Y/∆X) must be equal to the price ratio of the two goods. i.e.

MRSxy = Px / Py

Slope of the Price Line to be Equal to the Slope of Indifference Curve

: Price of X / Price of Y = MRS of X for Y

Second order condition: Sufficient Condition

The second order condition is that indifference curve must be convex to the origin at the point
of tangency. It means marginal rate of substitution of good X for good Y (MRSxy=∆Y/∆X) is
diminishing.

The above graph shows the consumer equilibrium. The point at which IC curve intersect the
budget line that point is called as Consumer Equilibrium.

Consumer’s equilibrium is affected by change in his income, change in the price of

substitutes, and change in the price of good consumed. These changes are known as (1)
Income effect (2) Substitution effect and (3) Price effect, respectively.

12
1. Income Effect
The income effect may be defined as the effect on the purchases of the consumer caused by
change in income, if price remains constant. Income effect indicates that, other things being
equal, increase in income increases the satisfaction of the consumer. As a result, equilibrium
point shifts upward to the right. On the contrary, decrease in income decrease the satisfaction
of the consumer and his equilibrium point shifts downwards to the left.

In this diagram consumer’s initial equilibrium is at point E 2 on price line A2B2. When his
income increases, his equilibrium point shifts to the right i.e. E 3 on price line A3B3. With
decrease in his income, his equilibrium point shifts to the left i.e. E 1 on price line A1B1. Locus
of all these equilibrium points is called income consumption curve. It starts from the point of
origin 0 meaning thereby that when the income of the consumer is zero, his consumption of
apples and oranges will also be zero.

Income Consumption Curve:

This curve is a locus of tangency points of price lines and indifference curves.
Income consumption curve refers to the effect of change in income on the equilibrium of the
consumer.
Slope of income consumption curve is positive in case of normal goods, but it is negative in
case of inferior goods.
Kinds of Income Effect
(i) Positive Income Effect: Income consumption curve is positive in case of normal
goods. In other words, consumption of both normal goods (x and y) increases with
increase in income. As shown in the diagram, income consumption curve (ICC) of
normal goods slopes upwards from left to right signifying that more of both the
goods will be bought when income increases. ICC curve indicates that expenditure

13
 on both the goods will increase in almost the same ratio.

(ii) Negative Income Effect:

Income effect of inferior goods is negative. It means inferior goods are brought in less
quantity when income of the consumer increases. Suppose x-good ( Wheat) is inferior and y-
good( Rice) is normal. This decline in quantity demanded reflects negative income effect. By
joining together different equilibrium points one gets income consumption curve which
slopes backward to the left. It indicates negative income effect.

(iii) Zero Income Effect: With the change in income, there is no change in the quantity
purchased of a commodity.

14
Income Effect with change in real income change
The real income effect rests on the observation that a change in price affects the purchasing
power of a given amount of income.
• Higher Price: An increase in price causes a decrease in the purchasing power of
income. This restricts the ability to purchase a good and the quantity
demanded decreases.
• Lower Price: A decrease in price causes an increase in the purchasing power of
income. This enhances the ability to purchase a good and the quantity demanded
increases.

2. Substitution Effect:
Given the constant income, if with the change in the prices of goods, the consumer will
substitute relatively lower-priced good for higher-priced ones. Consequently, it will affect the
quantity purchased of both the goods. This effect is known as substitution effect.
Substitution effect shows the change in the quantity of the goods purchased due to change in
the relative prices alone while money income remains constant.

For instance, a consumer consumes burgers and hot dogs. If the price of burgers goes up, but
the price of hot dogs stays the same, you might be more inclined to buy a hotdog. This
tendency to change your purchase based on changes in relative price is called the substitution
effect. When the price of burgers goes up, it makes burgers relatively expensive and hot dogs
relatively cheap, which influences you to buy fewer burgers and more hot dogs than you
usually would. Likewise, a decrease in burger price would cause you to eat more burgers and
fewer hot dogs, according to the substitution effect.

15
3. Price - Effect:
Price effect means change in the consumption of goods when the price of either of the two
goods changes, while the price of the other good and the income of the consumer remain
constant.

When the price of a commodity changes, it has two effects:

(i) There is change in the real income of the consumer leading to change in his consumption.
It is called income effect;
(ii) Secondly, due to change in relative prices, the consumer substitutes relatively cheaper
goods for the dearer ones. It is called substitution effect. The combination of this income and
substitution effect is called price effect.

Price effect is divided into two categories:

1) In case of Related Goods

Supposing IC1 is the original indifference curve and AB the original price line and consumer
is in equilibrium at point T 1. As the price of Good X falls, price line will shift to AC which
touches higher indifference curve IC2 at point T2. It means fall in price of any good will
increase the satisfaction of the consumer.
When the price of good X is falling it will increase the consumption of X commodity
and decrease the Consumption of Y commodity.

16
2) In case of Unrelated Goods

IC2 IC3
IC1

On the contrary, if the price of Good X falls further, the new price line will be AD which will
touch the higher indifference curve IC3at point T3, the new equilibrium point.

By joining together different equilibrium points T 1, T2 and T3 one gets the price consumption
curve (PCC). The price consumption curve for commodity X is the locus of points of
consumer’s equilibrium when the price of only X varies, the price of Y and income of the
consumer remaining constant.

Substitution Effect will always be non-positive (i.e., negative or zero). Unlike the
Substitution Effect, the Income Effect can be both positive and negative depending on
whether the product is a normal or inferior good.

Price Effect is the Sum of Substitution Effect and Income Effect

Thus, Price Effect = Income Effect + Substitution Effect.

Here you have to make the draw the following graph

17
In this graph AB1 & AB2 shows the substitution effect in which price of Good X is changing
and that leads to decrease in the consumption of GOOD X and increase the consumption of
GOOD Y because good Y considered to be the cheaper good as compare to good X.

In the same graph A3B3 budget line shows the Income effect. In this the income of the
consumer changes because of the taxes. Taxes leads to decrease in income level and which
shift the budget line to left and also lead to decrease in the consumption of both the
commodities.

When we combine these two effect it will give the PRICE EFFECT.

18