BE/U2 Topic 4 Ordinal Utility Approach
The basic idea behind ordinal utility approach is that a consumer keeps number of pairs of two commodities in his mind which give him equal level of satisfaction. This means that the utility can be ranked qualitatively.
The ordinal utility approach differs from the cardinal utility approach (also called classical theory) in the sense that the satisfaction derived from various commodities cannot be measured objectively.
Ordinal theory is also known as neo-classical theory of consumer equilibrium, Hicksian theory of consumer behavior, indifference curve theory, optimal choice theory. This approach also explains the consumer’s equilibrium who is confronted with the multiplicity of objectives and scarcity of money income.
The important tools of ordinal utility are:
- The concept of indifference curves.
- The slop of I.C. i.e. marginal rate of substitution.
- The budget line.
Assumptions of Ordinal Utility Approach
It is assumed that the consumer is rational who aims at maximizing his level of satisfaction for given income and prices of goods and services, which he wish to consume. He is expected to take decisions consistent with this objective.
- Ordinal Utility
The indifference curve assumes that the utility can only be expressed ordinally. This means the consumer can only tell his order of preference for the given goods and services.
- Transitivity and Consistency of Choice
The consumer’s choice is expected to be either transitive or consistent. The transitivity of choice means, if the consumer prefers commodity X to Y and Y to Z, then he must prefer commodity X to Z. In other words, if X= Y, Y = Z, then he must treat X=Z. The consistency of choice means that if a consumer prefers commodity X to Y at one point of time, he will not prefer commodity Y to X in another period or even will not consider them as equal.
It is assumed that the consumer has not reached the saturation point of any commodity and hence, he prefers larger quantities of all commodities.
- Diminishing Marginal Rate of Substitution (MRS)
The marginal rate of substitution refers to the rate at which the consumer is ready to substitute one commodity (A) for another commodity (B) in such a way that his total satisfaction remains unchanged. The MRS is denoted as DB/DA. The ordinal approach assumes that DB/DA goes on diminishing if the consumer continues to substitute A for B.