ordinal theory

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THE ORDINAL THEORY:

Indifference Curve Approach

(CONSUMER CHOICE)

UNIT 8



The Theory of Consumer Choice Is utility measurable?

Cardinal theory says that it is measurable just asprice and quantities are.

We can assign a number of units to eachcommodity. For example, an orange=5 units & an apple= 6 units.

The Ordinal theory says that utility is notmeasurable like prices & quantities.

We can only say whether the utility of an orangeis less than, equal to, or greater than the utilityof an apple.



The Budget Constraint

The budget constraint depicts theconsumption ‘bundles’ that a consumer

can afford. People consume less than they desire because

their spending is constrained, or limited, bytheir income.




It shows the various combinations of goods the consumer can afford given hisor her income and the prices of the twogoods.




Pints ofPepsi

Number ofPizzas

Spendingon Pepsi

Spendingon Pizza

TotalSpending

0 10050 90

100 80150 70200 60250 50300 40

350 30400 20450 10500 0




Pints ofPepsi

Number ofPizzas

Spendingon Pepsi

Spendingon Pizza

0 100 $ 0 $1,00050 90 100 900

100 80 200 800150 70 300 700200 60 400 600250 50 500 500300 40 600 400

350 30 700 300400 20 800 200450 10 900 100500 0 1,000 0




Pints ofPepsi

Number ofPizzas

Spendingon Pepsi

Spendingon Pizza

TotalSpending

0 100 $ 0 $1,000 $1,00050 90 100 900 1,000

100 80 200 800 1,000150 70 300 700 1,000200 60 400 600 1,000250 50 500 500 1,000300 40 600 400 1,000

350 30 700 300 1,000400 20 800 200 1,000450 10 900 100 1,000500 0 1,000 0 1,000



The Budget Constraint Line

Any point on the budget constraint lineindicates the consumer’s combination ortrade-off between two goods.

For example, if the consumer buys nopizzas, he can afford 500 litres of Pepsi. If he buys no Pepsi, he can afford 100

pizzas.




Quantity

of Pizza

Quantityof Pepsi

0

250

50 100

500




Quantity

of Pizza

Quantityof Pepsi

0

250

50 100

500B

A




Quantity

of Pizza

Quantityof Pepsi

0

250

50 100

500B

A

Consumer’s budget constraint




Alternately, the consumer can buy 50pizzas and 250 litres of Pepsi.




Quantity

of Pizza

Quantityof Pepsi

0

250

50 100

500B

C

A

Consumer’s budget constraint




The slope of the budget constraint lineequals the relative price of the two goods,that is, the price of one good compared tothe price of the other.




It measures the rate at which theconsumer will trade one good for theother.



Preferences:

What the Consumer Wants

A consumer’s preference amongconsumption bundles may be illustratedwith indifference curves.



Preferences:

What the Consumer Wants

An indifference curve shows bundles of goods that leave the consumer equallysatisfied.

Indifference Curve Approach developed byHicks and Allen.



Indifference Curves

Quantity

of Pizza

Quantityof Pepsi

0



Indifference Curves

Quantity

of Pizza

Quantityof Pepsi

0

Indifferencecurve, I 1



Indifference Curves

The consumer is indifferent, or equallyhappy, with the combinations shown atpoints A, B, and C because they are all onthe same curve.



Indifference Curves

Quantity

of Pizza

Quantityof Pepsi

0




Indifference Curves

Quantity

of Pizza

Quantityof Pepsi

0

C

B

A Indifferencecurve, I 1



The Marginal Rate of

Substitution

The slope at any point on an indifferencecurve is the marginal rate of substitution.

It is the rate at which a consumer iswilling to trade one good for another.

It is the amount of one good that aconsumer requires as compensation to

give up one unit of the other good.



Indifference Curves

Quantity

of Pizza

Quantityof Pepsi

0




Indifference Curves

Quantity

of Pizza

Quantityof Pepsi

0


Slope




Substitution

Quantity

of Pizza

Quantityof Pepsi

0





Substitution

Quantity

of Pizza

Quantityof Pepsi

0

1


MRS



Properties of Indifference

Curves

Higher indifference curves are preferredto lower ones.

Indifference curves are downwardsloping.

Indifference curves do not cross.

Indifference curves are bowedinward.



Higher indifference curves

are preferred to lower ones.

Consumers usually prefer more of something to less of it.

Higher indifference curves representlarger quantities of goods than do lowerindifference curves.



Indifference Curves

Quantity

of Pizza

Quantityof Pepsi

0




Indifference Curves

Quantity

of Pizza

Quantityof Pepsi

0


I 2



Indifference Curves

Quantity

of Pizza

Quantityof Pepsi

0

C

B

A Indifferencecurve, I 1

I 2



Indifference Curves

Quantity

of Pizza

Quantityof Pepsi

0

C

B

A

D


I 2

ff



Indifference curves are

downward sloping.

A consumer is willing to give up one goodonly if he or she gets more of the othergood.

If the quantity of one good is reduced, thequantity of the other good must increase.

For this reason, most indifference curves

slope downward.

I diff




downward sloping.

Quantity

of Pizza

Quantityof Pepsi

0


I diff d t



Indifference curves do not

cross.

In order for preference rankings to beconsistent, indifference curves cannotintersect or cross.

If indifference curves were to cross theassumption that ‘more is preferred to less’ would be violated.

I diff d t



Indifference curves do not

cross.

Quantity

of Pizza

Quantityof Pepsi

0

C

A

B

I diff




bowed inward.

People are more willing to trade awaygoods that they have in abundance andless willing to trade away goods of whichthey have little.

These differences in a consumer’s marginal substitution rates causes his or

her indifference curve to bow inward.

I diff




bowed inward.

Quantity

of Pizza

Quantityof Pepsi

0

I diff




bowed inward.

Quantity

of Pizza

Quantityof Pepsi

0

Indifferencecurve

I diff




bowed inward.

Quantity

of Pizza

Quantityof Pepsi

14

8

0 2 3

Indifferencecurve

A

I diff




bowed inward.

Quantity

of Pizza

Quantityof Pepsi

14

8

0 2 3

Indifferencecurve

1A

MRS = 6

I diff




bowed inward.

Quantity

of Pizza

Quantityof Pepsi

14

8

43

0 2 3 6 7

Indifferencecurve

1A

B

MRS = 6

I diff




bowed inward.

Quantity

of Pizza

Quantityof Pepsi

14

8

43

0 2 3 6 7

Indifferencecurve

1

1

A

B

MRS = 6

MRS = 1



Extreme Indifference Curves

Perfect substitutes

Perfect complements



Perfect Substitutes

Two goods with straight-line indifferencecurves are perfect substitutes.

The marginal rate of substitution isconstant.



Perfect Substitutes

20-cent coins1 2 30

10-cent coins

6

4

2

I 1 I 2 I 3



Perfect Complements

Two goods with right-angle indifferencecurves are perfect complements.



Perfect Complements

75 Right Shoes0

LeftShoes

7

5 I 1

I 2

Optimisation: What the




Consumer Chooses

Consumers want to get thecombination of goods on the highest

possible indifference curve.However, the budget constraintmay restrict or limit the consumer

to a lower indifference curve.





Consumer Chooses

Combining the indifference curveand the budget constraint

determines the consumer’s optimalchoice.

The Consumer’s Optimal




Choice

Consumer optimum occurs at thepoint where the highest indifference

curve and the budget constraint aretangent.





Choice

The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.





Choice

The consumer’s valuation of the twogoods equals the market’s valuation.

Changes in Income Affect




Consumer Choices

An increase in income shifts thebudget constraint outward.

The consumer is able to choose abetter combination of goods on ahigher indifference curve.





Consumer Choices

Quantity

of Pizza

Quantityof Pepsi

0





Consumer Choices

Quantity

of Pizza

Quantityof Pepsi

0

I 1





Consumer Choices

Quantity

of Pizza

Quantityof Pepsi

0

New budget constraint

I 1





Consumer Choices

Quantity

of Pizza

Quantityof Pepsi

0


I 1

I 2





Consumer Choices

Quantity

of Pizza

Quantityof Pepsi

0

New optimum


I 1

I 2





Consumer Choices

Quantity

of Pizza

Quantityof Pepsi

0

New optimum


I 1

I 2

1. An increase in income shifts

the budget constraint outward…





Consumer Choices

Quantity

of Pizza

Quantityof Pepsi

0

New optimum


I 1

I 2



2. …raising pizza consumption…





Consumer Choices

Quantity

of Pizza

Quantityof Pepsi

0

New optimum


I 1

I 2



3. …and Pepsi

consumption.

2. …raising pizza consumption…



Normal versus Inferior Goods

If a consumer buys more of a good whenhis or her income rises, the good is calleda normal good.

If a consumer buys less of a good whenhis or her income rises, the good is calledan inferior good.

f G



An Inferior Good

Quantityof Pizza

Quantity

of Pepsi

0

A I f i G d



An Inferior Good

Quantityof Pizza

Quantity

of Pepsi

0

I 1

A I f i G d



An Inferior Good

Quantityof Pizza

Quantity

of Pepsi

0

Initial budgetconstraint

I 1

A I f i G d



An Inferior Good

Quantityof Pizza

Quantity

of Pepsi

0

Initialoptimum

I 1


A I f i G d



An Inferior Good

Quantityof Pizza

Quantity

of Pepsi

0


I 1


Initialoptimum

A I f i G d



An Inferior Good

Quantityof Pizza

Quantity

of Pepsi

0

Initialoptimum


I 1I 2


A I f i G d



An Inferior Good

Quantityof Pizza

Quantity

of Pepsi

0

Initialoptimum

New optimum


I 1I 2


A I f i G d



An Inferior Good

Quantityof Pizza

Quantity

of Pepsi

0

New optimum


I 1I 2

1. When an increase in income shifts

the budget constraint outward...


Initialoptimum

A I f i G d



An Inferior Good

Quantityof Pizza

Quantity

of Pepsi

0

Initialoptimum

New optimum


I 1I 2



2. ... pizza consumption rises,making pizza a normal good...


A I f i G d



An Inferior Good

Quantityof Pizza

Quantity

of Pepsi

0

Initialoptimum

New optimum


I 1I 2



3. ... but Pepsi

consumptionfalls, makingPepsi aninferior good.

2. ... pizza consumption rises,making pizza a normal good...


Changes in Prices Affect



g

Consumer Choices

A fall in the price of any good rotates thebudget constraint outward and changesthe slope of the budget constraint.




g

Consumer Choices

Quantity of Pizza

Quantityof Pepsi

0




g

Consumer Choices

Quantity of Pizza100

Quantityof Pepsi

500

0

I 1




g

Consumer Choices


Quantityof Pepsi

500

0

I 1Initial budget constraint




g

Consumer Choices


Quantityof Pepsi

500

0

I 1

Initial optimum

Initial budget constraint




g

Consumer Choices


Quantityof Pepsi

500

0

I 1

1. A fall in the price of Pepsirotates the budget constraintoutward…





g

Consumer Choices


Quantityof Pepsi

1,000

500

0

I 1







g

Consumer Choices


Quantityof Pepsi

1,000

500

0

I 1

I 2







Consumer Choices


Quantityof Pepsi

1,000

500

0

New optimum

I 1

I 2







Consumer Choices


Quantityof Pepsi

1,000

500

0

New optimum

I 1

I 2



2. …reducing pizza consumption…





Consumer Choices


Quantityof Pepsi

1,000

500

0

New optimum

I 1

I 2



2. …reducing pizza consumption…

3. …and

raising Pepsiconsumption.


Income and Substitution



Effects

A price change has two effects onconsumption.

An income effectA substitution effect

The Income Effect



The Income Effect

The income effect is the change inconsumption that results when a pricechange moves the consumer to a higher

or lower indifference curve. The consumer is...

...worse off when prices increase.

...better off when prices decrease.

The Substitution Effect




The substitution effect is the change inconsumption that results when a pricechange moves the consumer along an

indifference curve to a point with adifferent marginal rate of substitution.





When the price of a good increases, theamount of other goods that must be givenup increases.

A Change in Price:



Substitution Effect

A price change first causes the consumerto move from one point on a indifferencecurve to another on the same curve.

Illustrated by movement from point Ato point B.

A Change in Price:



Income Effect

After moving from one point to another onthe same curve, the consumer will moveto another indifference curve.

Illustrated by movement from point Bto point C.

Income and Substitution Effects




Quantity of Pizza

Quantity

of Pepsi

0




Quantity of Pizza

Quantity

of Pepsi

0

I 1







Quantity of Pizza

Quantity

of Pepsi

0

I 1

Initial optimum


A





Quantity of Pizza

Quantity

of Pepsi

0

A

I 1

Initial optimum






Quantity of Pizza

Quantity

of Pepsi

0

A

I 1

Initial optimum


B





Quantity of Pizza

Quantity

of Pepsi

0

Substitutioneffect A

I 1

Initial optimum


Substitution effect

B





Quantity of Pizza

Quantity

of Pepsi

0

Substitutioneffect

B

A

I 1

Initial optimum



Substitution effect





Quantity of Pizza

Quantity

of Pepsi

0

Substitutioneffect

B

A

I 1

I 2

Initial optimum



Substitution effect





Quantity of Pizza

Quantity

of Pepsi

0

Substitutioneffect

B

A

C New optimum

I 1

I 2

Initial optimum



Substitution effect





Quantity of Pizza

Quantity

of Pepsi

0

Income effect

Substitutioneffect

B

A

C New optimum

I 1

I 2

Initial optimum



Substitution effect

Income effect

How do wages affect labour

l ?



supply?

If the substitution effect is greater thanthe income effect for the worker, he orshe works more.

If income effect is greater than thesubstitution effect, he or she works less.

Conclusion



A consumer’s budget constraint shows thepossible combinations of different goodshe or she can buy given his or her income

and the prices of the goods. Indifference curves represent a

consumer’s combinations of preferencesbetween two goods.

Conclusion



Consumers prefer higher indifferencecurves to lower indifference curves.

The consumer optimises by choosing the

point on his budget constraint that lies onthe highest indifference curve.

Conclusion



Income effect is the change in consumptionthat arises because a lower price makes theconsumer better off.

Substitution effect is the change inconsumption that arises because a pricechange encourages greater consumption of the good that has become relatively

cheaper.

Conclusion



Income effect is reflected by themovement from a lower to a higherindifference curve.

Substitution effect is reflected by amovement along an indifference curve toa point with a different slope.



Exercise

Q.1. Illustrate properties of an indifference curvewith help of diagrams.

Q.2. Draw the indifference curves:

(a). between perfect substitutes like 250 mlPepsi bottles and 1 ½ litre Pepsi bottles.

(b). between perfect complementary like leftshoe and right shoe.

Q.3. Illustrate income effect for normal andinferior goods (Pizza and Pepsi) with a diagram.

ordinal theory

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