Theory of Consumer Behavior Ordinal Utility Approach 11302020

Theory of Consumer Behavior Ordinal Utility Approach 11/30/2020 Business Economics - Orinal Utility Approach 1

Ordinal Utility Approach • According to the concept of ‘ordinal utility’, the utilities derived from the consumption of commodities cannot be measured. • It is only an expression of the consumer’s preference for one commodity over another or one basket of goods over another. – The ordinal concepts permits us to say only that the consumer prefers an apple to an orange, but it does not indicate by how much. • Ordinal utility approach uses indifference curves • to analyze consumer behavior. 11/30/2020 Business Economics - Orinal Utility Approach 2

The concept of ordinal utility • Not a quantity or numerical value • An expression of the consumer’s preference • This concept is based on the following axioms – It may not be possible for a consumer to express his utility in quantitative terms. – A consumer can list all the commodities he consumes in the order of his preference 11/30/2020 Business Economics - Orinal Utility Approach 3

Assumptions • Rationality • Ordinal utility • Transitivity and consistency of choice • Diminishing marginal rate of substitution 11/30/2020 Business Economics - Orinal Utility Approach 4

Indifference curve Commodity Y • Also known as iso-utility curves or equal utility curves. The locus of points each representing a different combination of two goods yielding the same utility or level of satisfaction A B C D Commodity X 11/30/2020 IC Any combination of X and Y on the IC yields the same level of satisfaction. Therefore, the consumer is indifferent or equally happy with the combinations shown at points A, B , C and D and they are all the points on the indifference curve. Business Economics - Orinal Utility Approach 5

Indifference curve cont…. • Example 12 – Indifference schedule A Combination Sandwich Soft (X) Drinks (Y) A 1 10 B 2 6 C 4 3 D 7 1 Quantity of Y 10 8 B 6 C 4 D IC 2 0 11/30/2020 Business Economics - Orinal Utility Approach 1 2 4 Quantity of X 7 6

Indifference Map • The set of indifference curves makes the indifference map. Commodity Y Indifference map could be contained any number of indifference curves ranked in order of consumer preference i. e. higher indifference curves are preferred to lower ones. IC 4 IC 3 IC 2 IC 1 Commodity X 11/30/2020 Business Economics - Orinal Utility Approach 7

Properties of Indifference curves • ICs have a negative slope • ICs are convex to the origin • ICs never intersect • An upper indifference curve implies a higher level of satisfaction than the lower ones. 11/30/2020 Business Economics - Orinal Utility Approach 8

The Marginal Rate of Substitution (MRS) • MRS is the rate at which one commodity can be substituted for another, remaining the same level of satisfaction. • Therefore, it is the amount of one commodity that a consumer requires as compensation to give up one unit of the other commodity. • The MRS is given by the slope of the IC. 11/30/2020 Business Economics - Orinal Utility Approach 9

Marginal Rate of Substitution (MRS) cont…. • For example; Substitution of good X for good Y (MRSxy) – The amount of Y that the consumer is willing to exchange per unit of X and maintain the same level of satisfaction. – MRSxy measures the downward vertical distance (the amount of Y the consumer is willing to give up) per unit of horizontal distance (per additional unit of X required) 11/30/2020 Business Economics - Orinal Utility Approach 10

Marginal Rate of Substitution (MRS) cont…. • For example; Substitution of good X for good Y (MRSxy) – The amount of Y that the consumer is willing to exchange per unit of X and maintain the same level of satisfaction. – MRSxy measures the downward vertical distance (the amount of Y the consumer is willing to give up) per unit of horizontal distance (per additional unit of X required) 11/30/2020 Business Economics - Orinal Utility Approach 11

Marginal Rate of Substitution (MRS) cont…. • For example; Substitution of good X for good Y (MRSxy) – Assume a consumer consumes two commodities X & Y – Now the consumer substitutes X for Y, remaining the same utility level. – As a result, he losses a part of his utility in Y, 11/30/2020 Business Economics - Orinal Utility Approach 12

Marginal Rate of Substitution (MRS) cont…. • For example; Substitution of good X for good Y (MRSxy) – The total utility remains the same, only when, – So, that, 11/30/2020 Business Economics - Orinal Utility Approach 13

The Marginal Rate of Substitution (MRS) cont… MRS x, y = - ΔY ΔX = MUx MUy Slope of IC MRS y, x = 11/30/2020 - ΔX ΔY = MUy MUx Business Economics - Orinal Utility Approach 14

Example: Marginal Rate of Substitution 12 10 Quantity of Y Find MRSxy between points, A A and B B and C 8 C and D B 6 C 4 2 0 11/30/2020 D 1 2 4 Quantity of X 7 Business Economics - Orinal Utility Approach 15

Example 12 Quantity of Y 10 8 MRSxy between points, A A and B = MRS xy = 4 -4 Y B 6 1 X C 4 2 0 11/30/2020 D 1 2 4 Quantity of X 7 Business Economics - Orinal Utility Approach 16

Example 12 10 Quantity of Y MRSxy between points, A B and C = MRS xy = 4 8 B 6 MRS xy = 1. 5 -3 Y 4 2 X 2 0 11/30/2020 C 1 D 2 4 Quantity of X 7 Business Economics - Orinal Utility Approach 17

Example 12 10 Quantity of Y MRSxy between points, A C and D = MRS xy = 4 8 B 6 MRS xy = 1. 5 C 4 -2 Y 2 0 11/30/2020 MRS xy = 0. 667 D 3 X 1 2 4 Quantity of X 7 Business Economics - Orinal Utility Approach 18

Diminishing Marginal Rate of Substitution (DMRS) • Decrease in MRS as the stock of x increases and that of Y decreases. 12 A 10 Quantity of Y MRS xy = 4 8 ΔY 1 6 ΔX 1 B MRS xy = 1. 5 ΔY 2 4 ΔX 2 C MRS xy = 0. 667 2 0 11/30/2020 ΔY 3 D ΔX 3 1 2 4 Quantity of X Business Economics - Orinal Utility Approach 7 19

Why does MRS diminish? • Two commodities are not perfect substitutes. • The quantity of a commodity available to the consumer. – The combination of two goods at a point of IC includes a large quantity of one commodity (Y) and a small quantity of the other (X). – Therefore consumer’s capacity to sacrifice Y is greater than to sacrifice X. 11/30/2020 Business Economics - Orinal Utility Approach 20

Budget constraint and budget line • A utility maximizing consumer would like to reach the highest possible IC on his indifference map. • But the consumer is assumed to have a limited income. – The limitedness of income acts a constraint on the utility maximizing behaviuor of the consumer. • Budget constraint 11/30/2020 Business Economics - Orinal Utility Approach 21

Budget constraint and budget line • Assume that a consumer spends his entire income on the two commodities, X (sandwich) and Y (soft drink). • The budget constraint is, 11/30/2020 Business Economics - Orinal Utility Approach 22

Budget line Commodity Y • Shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods. Any point on the budget constraint line indicates the consumer’s combination or trade –off between two goods. Budget Line Commodity X 11/30/2020 Business Economics - Orinal Utility Approach 23

Slope of the budget line Commodity Y A M/Py = OA ΔQy OA Since M/Py = OA and M/Px = OB The slope of the budget line can be expressed as, ΔQx M/Px = OB O OB Commodity X B 11/30/2020 Business Economics - Orinal Utility Approach 24

Example • If a consumer’s income is Rs. 10, 000 and the price of the commodity X is Rs. 100 and Y is Rs. 200 – Derive the budget line. – Find the slope of the budget line 11/30/2020 Business Economics - Orinal Utility Approach 25

Shift in budget line • The budget will changes due to the changes in – Consumer income Commodity Y Upward Shift due to increase in consumer income Downward Shift due to decrease in consumer income Commodity X 11/30/2020 Business Economics - Orinal Utility Approach 26

Shift in budget line cont… • The budget will changes due to the changes in Commodity Y – Prices of the commodities For Example, If Px decreases, while Py remains constant B. L shifts rightward only from X axis If Py increases, while Px remains constant B. L shifts downward only from Y axis Commodity X 11/30/2020 Business Economics - Orinal Utility Approach 27

Consumer Equilibrium • The rational consumer seeks to maximize the utility or satisfaction received in spending his income. • Therefore he maximizes his utility by trying to attain the highest possible indifference curve, given his budget line. 11/30/2020 Business Economics - Orinal Utility Approach 28

Consumer Equilibrium Cont…. • Conditions to be satisfied for the consumer to be in equilibrium. Necessary or First order condition – MRS xy must be equal to the price ratio Px/Py • MRS xy = Px/Py Supplementary or Second order condition – • 11/30/2020 first order condition must be fulfilled at the highest possible indifference curve. Business Economics - Orinal Utility Approach 29

Commodity Y Consumer Equilibrium Indifference curves IC 1, IC 2 and IC 3 represent a hypothetical indifference map of a consumer and his budget line is given by the line AB. The budget line AB is tangent to IC 2 at point E which is the consumer equilibrium and this point satisfies both first and the seconditions. A P Qy E IC 3 IC 2 Q Qx 11/30/2020 IC 1 B Commodity X Business Economics - Orinal Utility Approach 30

Changes in Income and Consumer Behavoiur • Income effect on normal goods – These are the goods whose consumption increases with increase in consumer income. • Income effect on inferior goods – These are the goods whose consumption decreases with increase in consumer income. 11/30/2020 Business Economics - Orinal Utility Approach 31

Commodity Y Income effect on Normal Goods ICC is the locus of points representing various combinations of two commodities purchased by the consumer at different levels of his income all other things remaining the same. G E Income Consumption Curve (ICC) C E 4 When consumer income increases, prices remaining constant, his budget line shifts upward parallel to the original budget line and vice-versa. E 3 A E 2 This means that when the income increases the consumer can consumes more quantities from both goods (normal goods) E 1 B 11/30/2020 D F H Commodity X Business Economics - Orinal Utility Approach 32

Commodity Y Income effect on Inferior Goods E C Y 2 ICC E 3 When X is the inferior good A Y 1 E 2 E 1 X 2 11/30/2020 B D Commodity X F Business Economics - Orinal Utility Approach 33

Commodity Y Income effect on Inferior Goods cont…. . When Y is the inferior good E C A Y 2 E 1 E 2 E 3 Y 1 ICC X 1 11/30/2020 B D X 2 F Business Economics - Orinal Utility Approach Commodity X 34

Engle Curve and Its Derivation M 4 Commodity Y M 3 ICC E 4 M 2 E 3 M 1 E 2 E 1 X 2 X 3 X 4 Consumer income While ICC shows the relationship between income and quantity consumed of a commodity Engle curve shows the relationship between income and expenditure. However ICC provides necessary information required to draw the Engle curve. Commodity X Engle Curve Engle curve is the graphical presentation of the relationship between equilibrium quantity purchased of a commodity and the consumer income M 4 M 3 M 2 M 1 11/30/2020 X 1 X 2 X 3 X 4 Quantity X Business Economics - Ordinal Utility Approach 35

Commodity Y Changes in Price and Consumer Behaviour When price of a commodity changes, all other things remaining constant, the position and the slope of the budget line changes. It changes the consumer’s budgetary option – Price effect. A E 1 E 2 B E 3 D E 4 Price Consumption Curve (PCC) F H Commodity X 11/30/2020 Business Economics - Orinal Utility Approach With the successive fall in the price of X, consumer equilibrium shifts from E 2 to E 3 to E 4. The shift in equilibrium shows the change in equilibrium quantities of X and Y. By joining these points we can derive the PCC which shows the consumer’s response to change in price of X. 36

Derivation of consumer Demand Curve Commodity Y A E 1 (PCC) E 2 X 1 BX 2 E 3 X 3 C D Commodity X Price P 3 P 2 Dx P 1 11/30/2020 X 1 X 2 Economics X 3 - Orinal Utility Business Approach Quantity of X 37

Income & Substitution effect of Price change • Price effect – Income effect • Arises due to change in consumer’s real income. – Substitution effect • Arises due to change in the relative prices. • Method – Hichsian method 11/30/2020 Business Economics - Orinal Utility Approach 38

Income & Substitution effect of Price change • Price change – Increase in price • Normal goods • Inferior goods – Decrease in price • Normal goods • Inferior goods 11/30/2020 Business Economics - Orinal Utility Approach 39

Income & Substitution effect of Decrease in Price Hicksian Compensation Approach Normal Goods Quantity of Y M E 1 E 2 E 3 Decrease in price of X IC 2 IC 1 Substitution Effect X 1 X 2 Income effect X 2 X 3 X 1 X 2 X 3 N N 1 Quantity of X 11/30/2020 Price Effect - Orinal Utility X 1 X 3 Business Economics Approach 40

Income & Substitution effect of Decrease in Price Inferior Goods Income effect of inferior goods is negative. Quantity of Y M E 2 E 1 IC 2 E 3 IC 1 Fall in price of X Substitution Effect X 1 X 3 Income effect -X 2 X 3 X 1 X 2 X 3 11/30/2020 Price Effect X 1 X 2 N N 1 Quantity of X Business Economics - Orinal Utility Approach 41