INDIFFERENCE CURVE ANALYSIS or ORDINAL THEORY

Q1. Define the following.

1. Indifference curve: An indifference curve is the locus of different combinations of two
goods, the consumer can consume, where each of the combination gives some
satisfaction.
2. Indifference Map: The set of all possible indifference curves the consumer has, is called
indifference map, where each. It shows different levels of satisfaction.
3. Budget line: Budget line is locus of all the feasible combinations of two goods that a
consumer can buy, by spending his whole income, with given prices.
4. Marginal Rate of Substitution (MRS): It is the rate at which the consumer is willing to
sacrifice one good to obtain one more unit of other good.
5. Marginal rate of exchange (MRE): It is the rate at which market requires the sacrifice of
one good to obtain an additional unit of another good. MRE is the price ratio i.e., price of
good obtained to the price of good sacrificed.

Q2. What is the difference between cardinal and ordinal approach?

CARDINAL ORDINAL

This approach assumes that utility or
satisfaction can be measured in terms of
utils.
Assumptions of cardinal approach are
impractical and unrealistic.
It does not differentiate between inferior and
giffen goods.
Used to find equilibrium for single
commodity and multiple commodity case
This approach assumes that utility
cannot be measured but can be
compared i.e., expressed in terms
of ranking.
Assumptions of ordinal approach
are practical and realistic
It helps in bringing out the
difference between inferior and
giffen goods.
Used to find equilibrium for two
commodity case only.

Q3. What are the assumptions on which indifference curve analysis is based?
1. Consumer is rational: it means consumer seeks to maximize utility or satisfaction in
spending his income.
2. Ordinal measurability: It means satisfaction can not be measured but it can be compared.
Consumers can mark his preferences.
3. Monotonic preferences: This assumption means better, more utility i.e., utility is an
increasing function of consumption and this is called monotonic function. The
 preferences based on monotonic utility preferences are called monotonic preferences.
This means that as consumption increases total satisfaction increases with it.
Q4. Define indifference curve and give a schedule of IC.
ANS. It is locus of different combinations of two goods the consumer can consume, where
each combination gives same level of satisfaction.

APPLES MANGOES
20 1
15 2
11 3
8 4
6 5

All the combinations will give the same level of satisfaction.

Q5. Explain the properties of indifference curve.
ANS.
1. IC slopes downward from left and right.
IC is negatively sloped because when consumer increases consumption of one good, he
must reduce the consumption of other good. So as to remain on the same level of
satisfaction i.e., on the same IC. It means consumption of one good is at the cost of the
other good.
2. Indifference curve is strictly convex to origin.
Convexity means slope of the curve is diminishing. Slope of IC is MRS (i.e., Marginal Rate of
Substitution) = change in y. It means how much
change in x
of a good is a consumer willing to forgo to consume an additional unit of other good such that
his satisfaction remains same.
3. Higher IC means higher satisfaction
This is because of the assumption of monotonic preferences where more is better (i.e., more
consumption leads to higher satisfaction). Higher IC represents more quantity of goods
consumed which means more satisfaction.
4. Two IC’s never intersect.
Each IC shows one level of satisfaction if we assume that two ICs are intersecting then two ICs
with different level of satisfaction will show same satisfaction at the point of intersection which
is not feasible. So, two ICs can never intersect.
Q6. Define budget set, budget constraint and budget line.
ANSWER
1. Budget set refers to the set of all the possible combinations of two goods that a consumer
can buy, by spending whole or less than whole income at a given price.
2. Budget constraint is an equation which explains that the amount of money spent on the
two goods by the consumer cannot be more than income of the consumer.
Px*Qx + Py*Qy < M.
3. Budget line is a locus of all the feasible combinations of two goods which a consumer
can buy by spending his whole income at given prices. Combination of two goods, cost
the consumer exactly his incomes.

Budget line Budget set

1 definition Definition

2 All the bundles of budget line are a It is a broader concept as it includes all the
part of budget set. feasible combinations where consumer is
spending whole or less than whole
income.

3 PxQx + PyQy = M PxQx + PyQy < M.

4 as we can see in the graph AB is the As we can see in the graph AOB is the
budget line. budget constraint.

Q7. Explain the conditions of consumer equilibrium by ordinal approach.

Ans. Consumer equilibrium means maximum level of satisfaction for a consumer with given
budget constraint.
Conditions of consumer equilibrium
1. MRS = MRE (necessary condition) i.e., slope of IC = slope of budget line.
2. MRS continuously falls i.e., slope of IC continuously falls (sufficient condition).
MRS is the number of units of a good that a consumer is willing to sacrifice to obtain one extra
unit of other good in the market.
MRE is the price ratio i.e., the rate at which consumer has to sacrifice a good to obtain one extra
unit of another good.

When MRS > Px, it needs to obtain one more unit of good X,
Py
Consumer is willing to sacrifice more good Y than what the market requires. It means consumer
values good X more than what market values. This means gain for the consumer, which induces
him to buy more of good X, this means MU of good X falls. Therefore, consumer is willing to
sacrifices less and less units of good Y as he consumes an extra unit of good X.
MRS continuously falls and becomes equal ratio at some combination of good X and good Y.
This is the consumer equilibrium point.
If MRS < MRE, it means to obtain one more unit of good X consumer is willing to sacrifice less
of good Y as compared to what market requires. It means consumer values good X more than
what market values. So, he will decrease the consumption of good X and increase the
consumption of good Y. MRS starts rising and this continues till MRS = MRE.

2) Second condition ensures that if MRS is not equal to MRE, than falling MRS leads to
equality.

Graphical equilibrium
Let the two goods be X & Y and their prices be Px and Py respectively. Consumer equilibrium is
the level of output where consumer maximizes his satisfaction with the given budget constraint.
In the given figure consumer equilibrium is at the point E where budget line is tangent to
indifference curve i.e.,
where slope of IC = slope of budget line.
Second condition is the slope of IC diminishes i.e.; IC is convex to the origin.
A consumer always tries to remain at the highest IC possible subject to his budget constraint. In
the diagram IC1, IC2 & IC3 are the three indifference curves and AB is the budget line which is
tangent to IC2 at the point E. This is the point of consumer equilibrium is OX of good X and OY
of good Y.
Consumer cannot get satisfaction level higher than IC2 because his income does not permit him
to come above the budget line AB. For example, point C and D on the budget line lie on the
lower IC and gives lesser satisfaction as compared to point E.
As budget line can be tangent to one and only one IC, consumer maximizes his satisfaction at
point E where both the conditions of consumer equilibrium are satisfied.

Q8. Graphically show changes in budget line with change in

a) Income – when income increases purchasing power also increases and when income
decreases purchasing power also decreases i.e., now with increase in income he can
afford more of good X or more of good Y or both the goods. So, when the budget line
shifts leftwards, when income decreases, purchasing power also decreases, so budget line
shifts leftwards.

Graph
b) When price of good X changes – It is assumed that the income of consumer and price of
good Y is given and there is change only in price of good X. When price of good X
decreases, purchasing power of good X increases which means budget line will shift
rightwards on X axis. In case of good X’s price increases, purchasing power of good X
decreases which means budget line will shift leftwards on X axis.