The Ordinal Theory: Indifference Curve Approach (Consumer Choice)

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 as price and quantities are. We can assign a number of units to each commodity. For example, an orange=5 units & an apple= 6 units. The Ordinal theory says that utility is not measurable like prices & quantities. We can only say whether the utility of an orange is less than, equal to, or greater than the utility of an apple.
The Budget Constraint
The budget constraint depicts the consumption bundles that a consumer can afford.
People consume less than they desire because
their spending is constrained, or limited, by their income.
It shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods.

Pints of Pepsi 0 50 100 150 200 250 300 350 400 450 500 Number of Pizzas 100 90 80 70 60 50 40 30 20 10 0 Spending on Pepsi Spending on Pizza Total Spending

Pints of Pepsi 0 50 100 150 200 250 300 350 400 450 500 Number of Pizzas 100 90 80 70 60 50 40 30 20 10 0 Spending on Pepsi $ 0 100 200 300 400 500 600 700 800 900 1,000 Spending on Pizza $1,000 900 800 700 600 500 400 300 200 100 0

Pints of Pepsi 0 50 100 150 200 250 300 350 400 450 500 Number of Pizzas 100 90 80 70 60 50 40 30 20 10 0 Spending on Pepsi $ 0 100 200 300 400 500 600 700 800 900 1,000 Spending on Pizza $1,000 900 800 700 600 500 400 300 200 100 0 Total Spending $1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000
The Budget Constraint Line
Any point on the budget constraint line indicates the consumers combination or trade-off between two goods. For example, if the consumer buys no pizzas, he can afford 500 litres of Pepsi. If he buys no Pepsi, he can afford 100 pizzas.

Quantity of Pepsi 500
250
50
100
Quantity of Pizza

250
50
A 100
Quantity of Pizza

250
Consumers budget constraint

A 100
50
Quantity of Pizza
Alternately, the consumer can buy 50 pizzas and 250 litres of Pepsi.

250
Consumers budget constraint

A 100
50
Quantity of Pizza
The slope of the budget constraint line equals the relative price of the two goods, that is, the price of one good compared to the price of the other.
It measures the rate at which the consumer will trade one good for the other.
Preferences: What the Consumer Wants
A consumers preference among consumption bundles may be illustrated with indifference curves.
Preferences: What the Consumer Wants
An indifference curve shows bundles of goods that leave the consumer equally satisfied. Indifference Curve Approach developed by Hicks and Allen.
Indifference Curves
Quantity of Pepsi
Quantity of Pizza
Indifference Curves
Quantity of Pepsi
Indifference curve, I1 0 Quantity of Pizza
Indifference Curves
The consumer is indifferent, or equally happy, with the combinations shown at points A, B, and C because they are all on the same curve.
Indifference Curves
Quantity of Pepsi
Indifference Curves
Quantity of Pepsi C
A 0
Indifference curve, I1 Quantity of Pizza
The Marginal Rate of Substitution
The slope at any point on an indifference curve is the marginal rate of substitution. It is the rate at which a consumer is willing to trade one good for another. It is the amount of one good that a consumer requires as compensation to give up one unit of the other good.
Indifference Curves
Quantity of Pepsi
Indifference Curves
Quantity of Pepsi
Slope Indifference curve, I1 0 Quantity of Pizza

Quantity of Pepsi

Quantity of Pepsi
MRS 1 Indifference curve, I1 0 Quantity of Pizza
Properties of Indifference Curves
Higher indifference curves are preferred to lower ones.
Indifference curves are downward sloping. Indifference curves do not cross. Indifference curves are bowed inward.
Higher indifference curves are preferred to lower ones.
Consumers usually prefer more of something to less of it. Higher indifference curves represent larger quantities of goods than do lower indifference curves.
Indifference Curves
Quantity of Pepsi
Indifference Curves
Quantity of Pepsi
I2 Indifference curve, I1 0 Quantity of Pizza
Indifference Curves
Quantity of Pepsi C
B I2 A 0 Indifference curve, I1 Quantity of Pizza
Indifference Curves
Quantity of Pepsi C
D I2 A Indifference curve, I1 Quantity of Pizza
Indifference curves are downward sloping.
A consumer is willing to give up one good only if he or she gets more of the other good. If the quantity of one good is reduced, the quantity of the other good must increase. For this reason, most indifference curves slope downward.
Indifference curves are downward sloping.

Quantity of Pepsi
Indifference curves do not cross.
In order for preference rankings to be consistent, indifference curves cannot intersect or cross. If indifference curves were to cross the assumption that more is preferred to less would be violated.
Indifference curves do not cross.

Quantity of Pepsi
C A B
Quantity of Pizza
Indifference curves are bowed inward.
People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little. These differences in a consumers marginal substitution rates causes his or her indifference curve to bow inward.

Quantity of Pepsi
Quantity of Pizza

Quantity of Pepsi
Indifference curve 0 Quantity of Pizza

Indifference curve 0 2 3 Quantity of Pizza

Quantity of Pepsi 14 MRS = 6 8 A 1
Indifference curve 0 2 3 Quantity of Pizza

4 3 0 2 3 6 7
B Indifference curve Quantity of Pizza

4 3 0 2 3
MRS = 1
1
6 7
Indifference curve Quantity of Pizza
Extreme Indifference Curves

Perfect substitutes Perfect complements
Perfect Substitutes
Two goods with straight-line indifference curves are perfect substitutes. The marginal rate of substitution is constant.
Perfect Substitutes
10-cent coins
6
2 I1 0 1 I2 2 I3 3 20-cent coins
Perfect Complements
Two goods with right-angle indifference curves are perfect complements.
Perfect Complements
Left Shoes
7 5
I2 I1
Right Shoes
Optimisation: What the Consumer Chooses
Consumers want to get the combination of goods on the highest possible indifference curve. However, the budget constraint may restrict or limit the consumer to a lower indifference curve.
Optimisation: What the Consumer Chooses
Combining the indifference curve and the budget constraint determines the consumers optimal choice.
The Consumers Optimal Choice
Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent.
The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.
The consumers valuation of the two goods equals the markets valuation.
Changes in Income Affect Consumer Choices
An increase in income shifts the budget constraint outward. The consumer is able to choose a better combination of goods on a higher indifference curve.

Quantity of Pepsi
Quantity of Pizza

Quantity of Pepsi
I1 0 Quantity of Pizza

Quantity of Pepsi

Quantity of Pepsi New budget constraint

I2

New optimum
I2

Quantity of Pepsi New budget constraint 1. An increase in income shifts the budget constraint outward New optimum
I2

Quantity of Pepsi New budget constraint 1. An increase in income shifts the budget constraint outward New optimum
I2
I1 0 2. raising pizza consumption Quantity of Pizza

Quantity of Pepsi New budget constraint 1. An increase in income shifts the budget constraint outward New optimum 3. and Pepsi consumption. I2
I1 0 2. raising pizza consumption Quantity of Pizza
Normal versus Inferior Goods
If a consumer buys more of a good when his or her income rises, the good is called a normal good. If a consumer buys less of a good when his or her income rises, the good is called an inferior good.
An Inferior Good
Quantity of Pepsi
Quantity of Pizza
An Inferior Good
Quantity of Pepsi
An Inferior Good
Quantity of Pepsi
Initial budget constraint I1 0 Quantity of Pizza
An Inferior Good
Quantity of Pepsi
Initial optimum
An Inferior Good
Initial optimum
An Inferior Good
Initial optimum
Initial budget constraint I1 0 I2 Quantity of Pizza
An Inferior Good
Initial optimum New optimum Initial budget constraint I1 0 I2 Quantity of Pizza
An Inferior Good
Initial optimum
1. When an increase in income shifts the budget constraint outward...
New optimum Initial budget constraint I1 0 I2 Quantity of Pizza
An Inferior Good
Initial optimum
New optimum Initial budget constraint I1 0 2. ... pizza consumption rises, making pizza a normal good... I2 Quantity of Pizza
An Inferior Good
3. ... but Pepsi consumption falls, making Pepsi an inferior good.

Initial budget constraint
Initial optimum
New optimum
I1 0
I2 Quantity of Pizza
2. ... pizza consumption rises, making pizza a normal good...
Changes in Prices Affect Consumer Choices
A fall in the price of any good rotates the budget constraint outward and changes the slope of the budget constraint.

Quantity of Pepsi
Quantity of Pizza

Quantity of Pepsi
500
I1 0 100 Quantity of Pizza

Quantity of Pepsi
500
Initial budget constraint 0

Quantity of Pepsi
500
Initial optimum I1 100 Quantity of Pizza

Quantity of Pepsi
500
1. A fall in the price of Pepsi rotates the budget constraint outward

Quantity of Pepsi 1,000 New budget constraint
500

500
I1 100

New optimum
500
I1 100

New optimum
500
I1
I2
Quantity of Pizza 100 2. reducing pizza consumption

New optimum
500
3. and raising Pepsi consumption. Initial budget constraint 0 I1
I2
Quantity of Pizza 100 2. reducing pizza consumption
Income and Substitution Effects
A price change has two effects on consumption. An income effect A substitution effect
The Income Effect
The income effect is the change in consumption that results when a price change 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 in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution.
The Substitution Effect
When the price of a good increases, the amount of other goods that must be given up increases.
A Change in Price: Substitution Effect
A price change first causes the consumer to move from one point on a indifference curve to another on the same curve. Illustrated by movement from point A to point B.
A Change in Price: Income Effect
After moving from one point to another on the same curve, the consumer will move to another indifference curve. Illustrated by movement from point B to point C.

Quantity of Pepsi
Quantity of Pizza

Quantity of Pepsi

0

Quantity of Pepsi
Initial optimum A

0

Quantity of Pepsi
Initial optimum A

0

Quantity of Pepsi
B A
Initial optimum

0

Quantity of Pepsi
B Substitution effect A
Initial optimum

0 Substitution effect

Quantity of Pepsi
New budget constraint
Initial optimum


Quantity of Pepsi
Initial optimum


Quantity of Pepsi
Initial optimum

I2 I1 Quantity of Pizza

Quantity of Pepsi
C New optimum B Substitution effect A I2 I1 0 Substitution effect Quantity of Pizza Initial optimum

Quantity of Pepsi
Income effect Substitution effect
C New optimum B A I2 I1 0 Substitution effect Income effect Quantity of Pizza Initial optimum
How do wages affect labour supply?
If the substitution effect is greater than the income effect for the worker, he or she works more. If income effect is greater than the substitution effect, he or she works less.
Conclusion
A consumers budget constraint shows the possible combinations of different goods he or she can buy given his or her income and the prices of the goods. Indifference curves represent a consumers combinations of preferences between two goods.
Conclusion
Consumers prefer higher indifference curves to lower indifference curves. The consumer optimises by choosing the point on his budget constraint that lies on the highest indifference curve.
Conclusion
Income effect is the change in consumption that arises because a lower price makes the consumer better off. Substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper.
Conclusion
Income effect is reflected by the movement from a lower to a higher indifference curve. Substitution effect is reflected by a movement along an indifference curve to a point with a different slope.
Exercise
Q.1. Illustrate properties of an indifference curve with help of diagrams. Q.2. Draw the indifference curves: (a). between perfect substitutes like 250 ml Pepsi bottles and 1 litre Pepsi bottles. (b). between perfect complementary like left shoe and right shoe. Q.3. Illustrate income effect for normal and inferior goods (Pizza and Pepsi) with a diagram.
Harcourt

The Ordinal Theory: Indifference Curve Approach (Consumer Choice)

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The Ordinal Theory: Indifference Curve Approach (Consumer Choice)

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THE ORDINAL THEORY: Indifference Curve Approach (CONSUMER CHOICE)

The Theory of Consumer Choice

The Budget Constraint

their spending is constrained, or limited, by their income.

The Budget Constraint

The Budget Constraint

The Budget Constraint

The Budget Constraint

The Budget Constraint Line

The Budget Constraint Line

The Budget Constraint Line

The Budget Constraint Line

Consumers budget constraint

The Budget Constraint Line

The Budget Constraint Line

Consumers budget constraint

The Budget Constraint Line

The Budget Constraint Line

Preferences: What the Consumer Wants

Preferences: What the Consumer Wants

Indifference curve, I1 0 Quantity of Pizza

Indifference curve, I1 0 Quantity of Pizza

Indifference curve, I1 Quantity of Pizza

The Marginal Rate of Substitution

Indifference curve, I1 0 Quantity of Pizza

Slope Indifference curve, I1 0 Quantity of Pizza

The Marginal Rate of Substitution

Indifference curve, I1 0 Quantity of Pizza

The Marginal Rate of Substitution

MRS 1 Indifference curve, I1 0 Quantity of Pizza

Properties of Indifference Curves

Higher indifference curves are preferred to lower ones.

Higher indifference curves are preferred to lower ones.

Indifference curve, I1 0 Quantity of Pizza

I2 Indifference curve, I1 0 Quantity of Pizza

B I2 A 0 Indifference curve, I1 Quantity of Pizza

D I2 A Indifference curve, I1 Quantity of Pizza

Indifference curves are downward sloping.

Indifference curves are downward sloping.

Indifference curve, I1 0 Quantity of Pizza

Indifference curves do not cross.

Indifference curves do not cross.

Indifference curves are bowed inward.

Indifference curves are bowed inward.

Indifference curves are bowed inward.

Indifference curve 0 Quantity of Pizza

Indifference curves are bowed inward.

Indifference curve 0 2 3 Quantity of Pizza

Indifference curves are bowed inward.

Indifference curve 0 2 3 Quantity of Pizza

Indifference curves are bowed inward.

B Indifference curve Quantity of Pizza

Indifference curves are bowed inward.

Indifference curve Quantity of Pizza

Extreme Indifference Curves

Perfect substitutes Perfect complements

Two goods with right-angle indifference curves are perfect complements.

Optimisation: What the Consumer Chooses

Optimisation: What the Consumer Chooses

The Consumers Optimal Choice

The Consumers Optimal Choice

The Consumers Optimal Choice