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Ordinal Utility Analysis Learning Objective

This document discusses consumer equilibrium using indifference curves and budget constraints. It defines key assumptions and properties of indifference curves including: downward sloping curves, convex shape, and inability to intersect. The budget line is introduced as representing affordable combinations given prices and income. Consumer equilibrium occurs where the highest indifference curve is tangent to the budget line, indicating no incentive to change consumption. The consumer aims to reach the highest attainable indifference curve subject to the budget constraint in order to maximize satisfaction.

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RohitPatial
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125 views

Ordinal Utility Analysis Learning Objective

This document discusses consumer equilibrium using indifference curves and budget constraints. It defines key assumptions and properties of indifference curves including: downward sloping curves, convex shape, and inability to intersect. The budget line is introduced as representing affordable combinations given prices and income. Consumer equilibrium occurs where the highest indifference curve is tangent to the budget line, indicating no incentive to change consumption. The consumer aims to reach the highest attainable indifference curve subject to the budget constraint in order to maximize satisfaction.

Uploaded by

RohitPatial
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Lecture-7

Ordinal Utility Analysis


Learning Objective: Properties of indifference curves, budget line and consumer
equilibrium
Before discussing the properties of indifference curves, it is important to understand the
assumptions which are made regarding the psychology of the consumer.
Assumption 1 : Non-satiety It is assumed that the consumer will always prefer large
amount of a good to a smaller amount of that good, provided the amount of other good at his
disposal remains unchanged.
Assumption II: Transitivity: Say there are three combinations A,B and C of two goods. If
the consumer is indifferent between A& B and B & C then it is assumed that he will be
indifferent between A and C also. This implies the consumers tastes are quite consistent.
Assumption III : Diminishing marginal rate of substitution It is assumed that if more and
more of good X is substituted for good Y, consumer will be willing to give up less and less of
the Y good for each incremental increase in the good X
Property I: Indifference curves slope downward to the right.
This is based on assumption I. Indifference curve being downward sloping means
when the amount of one good in the combination is increased; the amount of the other
good is reduced. This must be so if the level of satisfaction is to remain the same on
an indifference curve.
If for example the amount of good X is increased in the combination, while the
amount of good Y remains the same, new combination will be preferable to the
original one and the two combinations will not lie on the same indifference curve.
Hence an indifference curve on which different combinations of two goods yield the
same level of satisfaction to the consumer cannot assume a slope other than the
downward sloping to the right.
If the indifference curve is horizontal straight line (parallel to the X-axis) as shown
below, that would mean as the amount of the good X is increased, the amount of good
Y remained unchanged. But it cannot be so as per the assumption I.
According to this a consumer prefers a large amount of good to the smaller amount,
other things being the same. If indifference curve is horizontal as shown in Fig. it
means that combination A and B yield same level of satisfaction which is not true as
in combination B there are more units of good X as compared to A

Similarly if the shape of indifference curve is vertical (parallel to Y-axis) combination


A represent more of good Y with same units of good X compared with combination B.
Consequently A yield more satisfaction than B. So indifference curve cannot be
vertical to Y-axis because different combination on same curve yields different
satisfaction.

Consequently an indifference curve cannot be upward sloping as shown below.


Combination A which has more units of both the goods shows higher level of
satisfaction as compared to combination B but these two combination lie on the same
curve yielding different level of satisfaction . Hence indifference curve is downward
sloping from left to right only
Property II: Indifference curve will ordinarily convex to the point of origin.

If
not

indifference curve is
convex it can be
straight line or concave
origin. If it is straight
then
it
signifies
constant marginal rate
substitution and such
indifference curve can
be when goods are
perfect substitutes. It
shows that marginal
of substitution of apple
bananas
remains
constant as AB =

to the
line
of
an
only
rate
for
CD=EF

If indifference curve is concave to the origin as shown in the figure below, it signifies
the increasing marginal rate of substitution. Initially the consumer is willing to give
up one apple for an additional banana, and then he gives up 3 apples to get an
additional banana and so on. This means that as the quantity of bananas is increasing
its significance is also increasing which does not occur in real life.

So indifference curve is convex to origin as shown in the figure below.

Property III: Indifference curves cannot intersect each other


Each indifference curve represents different levels of satisfaction so they do not
intersect or touch each other. In figure two indifference curve IC 1 and IC2 have shown
intersecting each other at point M, but it is not possible.
Points M and L lies on IC 1 represent combinations of equal satisfaction. Similarly
Points M and N are on IC2 yielding equal level of satisfaction. This implies that
point L and N also yield equal level of satisfaction, but it is not possible, since L and
N lie on two different indifference curves yielding different level of satisfaction.
Hence two indifference curve cannot intersect each other.

Property IV: Higher indifference curve represent higher level of satisfaction than lower
the lower indifference curve

It can be seen from the figure that combinations A and B which lies on IC 1 and IC2
have same units of apple but different units of bananas. Combination B has more units
of banana gives higher level of satisfaction as compared to combination A. Hence it is
evident that higher the indifference curve higher is the level of satisfaction.

Budget line

Understanding of the concept of price line or budget line is essential for


understanding the theory of consumer's equilibrium. As explained above, a higher
indifference curve shows a higher level of satisfaction than a lower one. Therefore, a
consumer in his attempt to maximize his satisfaction will try to reach the highest possible
indifference curve. But in his pursuit of buying more and more goods and thus obtaining
more and more satisfaction he has to work under two' constraints: firstly, he has to pay the
prices for the goods and, secondly, he has a limited money income with which to purchase the
goods. Thus, how far he would go in-his purchases depend upon the prices of the goods and
the money income which he has to spend on the goods. As explained above, indifference map
represents consumer's scale of preferences between two goods. Now, in order to explain
consumer's equilibrium there is also the need for introducing into the indifference diagram
the price line which represents the prices of the goods and consumers money income.
The budget line is an important component when analyzing consumer behaviour. The budget
line illustrates all the possible combinations of two goods that can be purchased at given
prices and for a given consumer budget. Remember, that the amount of a good that a person
can buy will depend upon their income and the price of the good. With given budget and
prices of two goods budget line can be drawn. For example a consumer has Rs 100 to be
spent on two goods (say apple and banana) whose prices are Rs 10 and Rs 5.

Possible combinations which can be consumed with given budget as well as prices
Combinations

Apple

Banana

A
B
C
D

Price= Rs 10
0
1
2
3

Price= Rs 5
20
18
16
14

The possible schedule of purchase given the prices as well as income of the
consumer is presented in table. The graphic presentation is as shown above. Price
line shows the different combinations of two goods which consumer can buy.
What happens to the price line if either the price of goods changes or the income changes.

Suppose the price of banana falls from Rs 5 to Rs 3 , then consumer can buy more
bananas ( Price line PL2) and if the price increases then he will buy less ( price line
PL1) Similarly for apple as shown in the graph.
But when the income of the consumer changes and the prices of the goods remain
constant then price line shift upward (P2L2) or downward P1L1) and is parallel to
original price line PL.

Consumers equilibrium
We are now in a position to explain with the help of indifference curves how a
consumer reaches equilibrium position. A consumer is said to be in equilibrium when he is
buying such a combination of goods as leaves him with no tendency to rearrange his
purchases of goods. He is then in a position of balance in regard to the allocation of his

money expenditure among various goods. In the indifference curve technique the consumer's
equilibrium is discussed in respect of the purchases of two goods by the consumer. It is
assumed that consumer is rational and tries to maximize his satisfaction. For this following
assumptions are made:
1. The consumer has a given indifference map exhibiting his scale of preferences for
various combination of two goods Say Apple and banana.
2. He has a fixed amount of money to spend on the two goods. He has to spent whole of
his given money on the two goods.
3. Prices of the goods are given and constant for him.
4. Goods are homogeneous and divisible.

It can be seen from the graph above that indifference map shows the scale of
preferences of the consumer between various combinations of two goods, while the
price line PL shows the various combinations of two goods which he can afford with
his money income and given prices of two goods.
In order to maximize his level of satisfaction consumer will try to reach the highest
indifference curve which he could with a given expenditure of money at given prices.
The highest indifference curve to which consumer can reach is the curve to which
price line PL is tangent (IC0).
In figure, Points R and S also lie on the price line but they are on a IC which is lower
than ICo. It is thus clear that of all possible combinations lying on PL combination Q E

yields the maximum satisfaction to the consumer. At tangency point the slope of price
line and indifference curve are equal.
MRSXY = PX / PY
When the MRSXY of X for Y is greater than or less than the price ratio between two
goods it is advantageous for the consumer to substitute one good for the other. Thus at
point R marginal rate of substitution is greater than the price ratio, so consumer will
substitute good X for Y and will come down along the price line till it becomes equal to
the MRSXY.
At point S MRSXY is less than the given price ratio, consumer will substitute good Y
for good X and accordingly move up along the price line till it becomes equal to
marginal rate of substitution .
Questions
1.
a)
b)
c)
d)

Indifference Curve Technique is an improvement over


Utility analysis
Demand analysis
Substitution analysis
None of the above

2. The curve on which combinations of goods (yielding the same level of satisfaction) are
shown is known as
a)
b)
c)
d)

Supply curve
Demand curve
Indifference curve
All of the above

3.The concept of ------------------------ is the basis of indifference curve.


a)
b)
c)
d)
5.

Diminishing utility
Diminishing Marginal Rate of Substitution
Demand
All of the above
Consumer will be in equilibrium when
a) MRSxy > Px/Py
b) MRSxy< Px/Py
c) MRSxy = Px/Py
d) None of the above

5. Two budget lines involving same commodity prices, but different levels of consumer
income will be
a) Intersecting each other
b) Parallel to each other
c) Both a and b

d) All of the above

Answers
1a)
2 c)
3 b)
4 c)
5 b)

10

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