Ordinal Utility Approach
Indifference Curves Analysis
Baratha Dewanarayana
Senior Management Consultant/ Lecturer
Masters in Economics (UoC)
BSc in Business Administration (Special) in Business Economics (USJP)
baratha@nibm.lk
Introduction
The Ordinal utility approach is the oldest utility
approach and also known as the indifference curves
analysis.
The Ordinal utility approach reveals that the utility
can be ranked but cannot be measured absolutely
with numbers.
The Ordinal Utility approach starts with the
introduction to indifference curves.
Indifference Curve
refers to a curve which shows various consumption
combinations lead to identical level of utility to the
individual consumer whose consumption consists of
two commodities.
There are four
characteristics
of the indifference
curve
• Characteristics/Properties of indifference curve
Convex to the origin since two products shown are not perfect
substitutes
Negatively sloped since consumption of one product has to reduced
when consumption of the other is increased in order to keep the
utility constant
Indifference curves do not intersect each other
Indifference curves moving towards Northeast represent higher level
of utility to the consumer
Indifference
Map
Special Indifference curves
Indifference curves
when two
commodities
considered are
Perfect Substitutes
Special Indifference curves
Indifference curves
regarding Perfect
complementary goods
Slope of indifference curve
Slope of the
indifference curve is
measured in terms of
Marginal Utility for X
and Y (Two Products
considered)
• Therefore when consumption moves from point A to
point B,
Reduction of total utility due to decrease of product
Y, should equal to increase of utility due to increase
of product X.
But this should not exactly equal in terms of units
consumption of each product
Reduction of total utility (When consumption Y decreases)
∆Y * MUY
Increase of utility (when consumption X increases)
∆ X * MUX
Therefore ∆Y * MUY = ∆ X * MUX
further ∆Y / ∆ X = MUX/ MUY
∆Y / ∆ X is the Slope of indifference curve
Slope of indifference curve = MUX/ MUY
MUX/ MUY = MRS (Marginal rate of Substitution)
MRS refers to the rate at which an individual
consumer give up one product in exchange for the
other product in order to keep the level of utility
constant
The law of diminishing MRSxy
The behavior of
MRSxy is taken as a
the law of diminishing
marginal rate of substitution
Budget Constraint
Refers to a line that shows various consumption
combinations can be purchased at a given level of
income (expenditure).
Budget constraint represents the maximum
affordability of the individual consumers.
Budget Constraint
Budget constraint
determines what can be
purchased and what
cannot be
Budget Constraint
Budget constraint is derived on three (03)
determinants;
Px (Price of product x)
Py (Price of product Y)
Budget or individual income (I)
Budget Constraint
Activity: Assume an individual’s income is 1200LKR
and prices of two goods he consumes are Px = 40LKR
& Py= 30LKR. Construct the Budget constraint for the
scenario further assuming that the individual has no
savings.
Slope of Budget
Constraint
= ( I/Py)/ (I/Px)
= ( I/Py)* (Px/I)
= Px /Py
Budget Constraint
Changes of Budget Constraint
Changes of the determinants of the budget constraint are
caused to change the position of the Budget Constraint
Apply all
Possible
Changes by
Changing
Determinants
Consumer's Equilibrium
Both indifference curves and budget constraint
should be coupled together in order to understand
Consumer’s equilibrium under the Ordinal Utility
Approach
Consumer's Equilibrium
Consumer's Equilibrium
At the consumer’s equilibrium under the ordinal
utility approach;
The budget constraint is tangent to the respective
indifference curve (touches each other) where slope
of the budget constraint is equal to the slope of the
respective indifference curve
Consumer's Equilibrium
Therefore at the consumer’s equilibrium
Income Consumption Curve (ICC)
Refers to a curve which connects all the equilibrium
points under Ordinal utility approach due to changes
of consumer’s nominal income while prices of
products remain unchanged.
The type of
the ICC
determines the
type of goods
in consumption
Normal and Inferior
goods and ICC
Price Consumption Curve (PCC)
PCC is a curve which connects
all the consumer equilibrium
points only due to changes of
price of one of the products
when income and price of the
other product considered
remain constant
PCC and Individual’s Demand curve
Substitution and Income Effects
Changes of
Consumer’s
real income
cause to both
Substitution &
Income effects
Substitution & Income effect for an Inferior Good
