Ordinal Utility Analysis

(or Indifference Curve

Approach)
Netra Lal Subedi, BIC
 Concept of Ordinal Utility Analysis
• Initiated by F.Y. Edgeworth by inventing indifference curve technique. (Late
nineties )
• Refined and used extensively by Vilfredo Pareto, an Italian Economist.
• Made popular and greatly extended by J.R. Hicks and R.G.D. Allen in 1934 AD.
• Utility is only a psychological or subjective factor. So, this can be felt but not
measured in a numerical form
• Being a subjective phenomenon, utility can be ranked or put in order but not be
measured quantitatively as argued by Cardinal Analyst: Marshall, Pigou.
• Consumer can simply rank his preferences and say one basket of goods is
preferred over another.
• Also called indifference curve approach as technique of indifference curve is
used to explain the ordinal utility analysis.
 Assumptions of Ordinal Utility
Analysis
1. Rationality: The consumer is assumed to be rational, rational in the sense that he/she
tries to maximize the satisfaction given limited resources(budget) and price. It is
assumed he has full knowledge of all relevant information.
2. Ordinal utility: It is assumed that the consumer can rank their preference according to
the satisfaction of each basket.
3. Diminishing Marginal rate of substitution: The marginal rate of substitution is a rate at
which a consumer is willing to substitute one commodity (say Y) for each additional
unit of another (say X) so that the level of satisfaction reman same throughout.
4. Consistency of choice: It is assumed that the consumer is consistent in his choice, that
is, if in one period he chooses bundle A over B, he will not choose B over A in another
period if both bundles are available to him.
5. Transitivity of choice: It is assumed that consumer’s choices are characterized by
transitivity: if bundle A is preferred to B, and B is preferred to C, then bundle A is
preferred to C. symbolically, if A>B, and B>C, then A>C.
6. Non- Satiety: consumer has not reached the point of saturation in case of any
commodity. So, he always prefers more bundle of any goods.
 Indifference Curve
An Indifference curve is a locus of those combinations of any two goods which yields
same level of satisfaction to the consumer so that consumer is indifferent to choose
the particular combination. It means all the combinations are equally preferable to
him. Indifference curve is also called iso - utility curve or equal utility curve.
Assumptions:
1. Consumer is supposed to be rational.
2. Ordinal measurement of utility is possible.
3. Two goods X and Y are consumed.
4. Marginal rate of substitution is diminishing.
5. Consumer’s choices are transitive and consistent.
6. Total utility is function of quantity of the commodities consumed i.e., U=f(Q1, Q2,
….Qn)
Indifference Curve
Assumptions….. Contd.
7. Consumer has non-satiety in nature.
8. Consumer has scale of preferences.
Indifference schedule:
The tabular presentation of various combinations of two commodities providing
same level of satisfaction is known as indifference schedule.
A hypothetical indifference schedule is given below:
Table 2.18: Preference Schedule
Combinations Good X Good Y MRSXY =ΔY/ΔX
A 1 12 --
B 2 8 4:1
C 3 5 3:1
D 4 3 2:1
E 5 2 1:1
Indifference Curve
Indifference schedule….. Contd.
In the given table, five different combinations : A,B,C,D,E of two goods X
and Y are given. All these combinations provide same level of satisfaction
to the consumer so that consumer is indifferent choose any one of them:
either (1,12) or (2,8) or (3,5) or (4,3) or (5,2). The process of substitution
is based on the comparison of marginal utilities of two goods with the
theme of law of diminishing marginal utility.
The graphical presentation of indifferent schedule is called indifference
curve. When we plot all these combinations mentioned above, we
obtained a downward sloping convex curve, which is an indifference cure.
Indifference Curve
Indifference Curve

In the diagram, IC represents the

indifference curve, which is obtained
from graphical plotting of given
combinations: A, B, C, D, and E, that
provide equal utility. IC is downward
sloping implying that marginal rate of
substitution (MRS) is diminishing.
That is to say, for each unit increase
in X, consumer is sacrificing less and
less unit of Y.
 Indifference Map
A set of indifference curves is called indifference map. An indifference map
shows different indifference curves that represents ranking of preferences
of consumers. Among the various IC, the higher IC provides higher level of
satisfaction to the consumer. It is because, with higher IC, a consumer can
consume either more of both goods or more of at least one goods with
decreasing the amount of another.
Indifference Curve
Q.) What is an indifference curve? Explain the various properties of
indifference curve. [PU 2020-10 Marks, 2015-10 Marks]
• Indifference curve always slopes downward from left to right
• Indifference curve is convex to the origin.
• Higher indifference curve yields higher level of satisfaction than that
of lower once.
• Indifference curves never intersect to each other.
• Indifference curves never touches either of the axes.
• Indifference curve may or may not be parallel.
Properties of Indifference Curve
• Indifference curve always slopes downward from left to right
An indifference curve always slopes downward from lift to right. It is
because of the fact that when a consumer decides to consume more
units of one goods out of two , he will have to reduce the units of
another goods if the level satisfaction is to remain same on an
indifference curve. Y

Y1 A
In the figure, when quantity
Of X is increased from X to X1, Good
Y
Then quantity of Y has to be Y2 B

Reduced from Y1 to Y2 so that IC

Same level of satisfaction X

O X1 X2
is maintained. Good X
Properties of Indifference Curve
• Indifference curve is convex to the origin
An indifference curve is usually convex to the origin because of diminishing
marginal rate of substitution. That is t say, for each extra unit of one commodity
say X, a consumer sacrifices less and less unit of another commodity say Y. It is
because consumer’s intensity of need for X diminishes as he go on adding more
of X, so cost of X in terms of Y diminishes.

In the given diagram, moving from A to B

to C to D to E along IC, unit consumption
of X commodity is increased for which
less and less units i.e., 4, 3, 2, and 1 units
of Y has been sacrificed. It means, MRSxy is
diminishing due to which IC is convex to
origin.
Properties of Indifference Curve
• Higher indifference curve yields higher level of satisfaction than that of
lower once.
As consumer moves from lower to higher indifference curve, he can have either
more of both goods or at least more unit of one goods without reducing that of
that of another. That is why higher indifference curve provide higher level of
satisfaction.
In the given figure, at point D on IC2,
consumer is having more of both goods
(X2,Y2). At point B on IC2, consumer is having
more of Y without reducing X . Similarly, at
point C, consumer is having more of X
without reducing Y. Since more bundle of
goods provides more satisfaction, Higher IC
provides higher satisfaction.
 Properties of Indifference Curve
• Indifference curves never intersect to each other.
The two indifference curves never get intersected to each other because if
they got intersected, the meaning of Indifference curve would be invalid.
That is to say, the consistency and transitivity assumption of ordinal utility
would be invalid.
If the given diagram, from IC1, it is observed
point A and point C provide same level of
satisfaction. On the other hand, from IC2, it
is observed that point A and point B
provides equal satisfaction.
It concludes point A, B and C provide same
satisfaction which is wrong because of the
fact that satisfaction from B > satisfaction
from C, point B lying on higher IC.
 Properties of Indifference Curve
• Indifference curves never touches either of the axes.
If an indifference curve touches either one or both of the axes, because
it touches any one of both of the axes, then the meaning of IC would be
invalid.
let us consider point N on IC1 which
touches Y axis and point M on IC2 which
touches X-axis. Here, at both points,
only one commodity is seemed to be
consuming by consumer from whole
budget which invalidates IC’s meaning of
simultaneous consumption of two
commodities.
 Properties of Indifference Curve
• Indifference curve may or may not be parallel.
The two indifference curves may or may not be parallel because the marginal
rate of substitution between two commodities not necessarily be the same for
all indifference curves.

In the given diagram, IC2 is not parallel

to IC1 and IC3. However, the meaning
and other properties of indifference
curve is applied (or valid) in this case.
So, Indifference curves need not to be
parallel to each other.
 Marginal Rate of Substitution(MRS)
Marginal rate of substitution is the rate at which units of two goods are
exchanged (or substituted ) to each other to maintain same level of
satisfaction.
More precisely, marginal rate of substitution between X and Y i.e., (MRSxy )
refers to the amount of Y which a consumer has to give up for the gain of
each additional units of X so that his level of satisfaction remains the same.
In other words, MRSxy is the rate of change in Y to the change in X which
represents slope of IC is and is given as :
 Marginal Rate of Substitution(MRS)
Let us consider a consumer is consuming two goods ‘X’ and ‘Y’. In this case,
MRSxy is the rate at which ‘Y’ is sacrificed for each one unit increase in ‘X’.
The utility function is given as: , where X and Y are imperfect substitute.

In the given figure, let us suppose

that a consumer substitutes X for Y
such that total utility remains same.
When consumer sacrifice some
units of Y, his stock of Y decreases
by ΔY and so he loses a part of his
total utility. His loss of utility may be
expressed as : - ΔY MUy
 Marginal Rate of Substitution(MRS)
On the other hand, as a result of substitution, his stock of X increases by ΔX
and so he gains a part of total utility. His gain of utility may be expressed as :
+ΔX MUX.
The total utility remains same only when loss of utility is equal to gain of
utility
i.e.,
or,
or
Here, is simply the slope of Indifference Curve(IC) which gives the when
consumer substitutes X for Y.
Marginal Rate of Substitution(MRS)
Similarly, gives the when consumer substitute Y for X.
i.e.,
This means, is always negative and it represents the slope of IC. As slope
of IC is always negative, it slopes downward.
Alternative Method (Mathematical Derivation)
We have, IC = U= f(X,Y)
U= f(X,Y)
By total derivative,
Marginal Rate of Substitution(MRS)
Alternative Method (Mathematical Derivation)
For optimization (utility maximization), setting first order derivative of
utility function equals to zero, we get

Or,
Or,
Or,
Or,
, which is the slope of IC.
Marginal Rate of Substitution
Q.) “The marginal rate of substitution diminishes as we move down to
indifference curve”. Explain. [PU 2019-10 Marks]
Q.) The marginal rate of substitution always goes on diminishing.
Explain this statement with the table and diagram.
 Principle of Diminishing MRS
Marginal rate of substitution is the rate at which one commodity is substituted
for another to maintain same level of satisfaction. The marginal rate of
substitution of X for Y (MRS)XY is the amount of Y that will be given up for
obtaining each additional unit of X. Thus,

It can be explained through the following table.

Table 2.20: Principle of Diminishing MRS
 Principle of Diminishing MRS
In the table, when the consumer moves from the combination A to B in his
indifference schedule 4 unit of Y is sacrificed for the one more unit of X.
Hence, the marginal rate of substitution of X for Y is 4. This behaviour of the
consumer is known as the principle of diminishing marginal rate of
substitution.

In the figure 2.20, good-X and

good-Y are measured along the X-
axis and Y-axis respectively. In the
figure, each time when good-X
increases by 1 unit the units of Y
goods that should be given up from
4, 3, 2 to 1 units. As a result, MRS
goes on diminishing.
Why does MRS Diminish?
• The want for particular good is satiable:
• It is the diminishing intensity of need(want) for a particular commodity that is
responsible for diminishing MRS.
• Gods are imperfect substitutes of each other:
• If two goods are perfect substitute then they are exactly similar and so there is
no meaning of marginal sacrifice of one over another thereby making MRS
constant.
• Increase in the quantity of one good does not increase the wants satisfying
power of another
• If with the increase in X, the wants satisfying power of Y increases then greater
and greater amount of Y will be required to be given up for a unit increase in X so
that level of satisfaction remain same.
 Budget Line or Price Line
The utility maximizing consumer always tries to maximize satisfaction from the
consumption of more bundle goods. However, he is subject to the limited
income, which is called budget constraint.
Budget line or budget constraint is defined as the locus of various combinations
of two goods that a consumer can purchase from his given money income at
given market prices. It is also called price line.
It is mathematically expressed as:
……….(1)
Where, B=consumer’s budget
Py=price per unit of Y
Px=price per unit of X
X=quantity purchase of X
Y=quantity purchase of Y
 Derivation of Budget Line
Let us consider, a consumer is ready to purchase X and Y commodity from
his limited budget (B). Price of X is given as Px per unit and price of Y is
given as Py per unit.
In this situation, consumer’s budget is provided as
………………………….…..(1)
If consumer decides to spend his all money on purchase of X-commodity,
the purchase of Y would be zero.
i.e., , when Y=0
So, one edge of the budget line would be .
 Derivation of Budget Line
On the other hand, if consumer decides to spends his all money on the purchase
of Y commodity, then purchase of X would be zero.
i.e., , when X=0.
So, another edge of the budget line
would be

Now , when we join these two

points A and B , we get a
downward sloping curve AB
which is required budget line of
consumer.
Slope of Budget Line
We have, budget equation is:

or,
or,
or,
Comparing it with y=mx+c, we get
Slope (m)= , which is the required slope of budget line.
 Change in Budget Line: Shift and
Swing
Swing in Budget Line:
Other things remaining same, when price of a commodity changes (either
increase or decrease), it cause to swing in budget line:
-in case of increase in prices of a commodity only(keeping budget and price
of another commodity constant) , the real income( income in terms of
purchasing power) of consumer decreases as a result of which, consumer’s
budget line swings inward.
-in case of decrease in prices of a commodity only(keeping budget and price
of another commodity constant) , the real income( income in terms of
purchasing power) of consumer increases as a result of which, consumer’s
budget line swings outward.
Change in Budget Line: Shift and
Swing
Shift in Budget Line:
Whenever money income of consumer changes(either increase or
decrease) other things remaining same, it causes to shift in budget line:
-if money income of consumer increases, keeping the prices of
commodities constant, real income of consumer increases and so the
whole budget line shifts outward from its initial position.
-if money income of consumer decreases, keeping the prices of
commodities constant, real income of consumer increases and so the
whole budget line shifts inward from its initial position.
 Let’s Do….
Suppose Hari has Rs. 5000 money income spending on good X and good Y for
a month and price of X and Y are Rs. 100 and Rs. 50 respectively.
a. ….
a. Draw Hari’s Budget line
b. Assume Hari splits his money equally between X and Y at a given prices.
Show where he ends up on budget constraint.
b. ….
a. Let Hari’s income increases to Rs. 8000 from Rs. 5000. Draw Hari’s new
budget line.
b. Show the point of new equilibrium when he spends his new income equally
on X and Y goods at given budget.
c. Identify the nature of goods.
Any Questions??
Thank You!!!!