What is Ordinal Utility Analysis? | What is Indifference Curve? | What is Marginal Rate of Substitution? | What is Law of Diminishing Marginal Rate of Substitution?
Introduction
Till now in previous sessions, we discussed about the
consumer behavior. We noted that there are two prime approaches in economics
that we use to study the consumer behavior which are Cardinal Utility Analysis
and Ordinal Utility Analysis. We dwelled in detail to discuss the Cardinal
Utility Analysis. Cardinal Utility Analysis says that we can measure the
utility or satisfaction derived by consumer from consumption of any product or
commodity. And thus we have two measures that calculate the utility derived
which are Total Utility and Marginal Utility. We discussed the relationship
between the Total Utility and Marginal Utility. And studying the movement in
Marginal Utility, we came to the Law of Diminishing Marginal Utility. And
finally we relate the Demand Curve to the Marginal Utility and stated that the
source of the negative slope of demand curve denoting negative relation between
the price of the commodity and quantity demanded i.e., Law of Demand have its
inceptions from the Law of Diminishing Marginal Utility.
In this session, we will start the discussion of the second
approach used to study the consumer behavior based on utility i.e., Ordinal
Utility Analysis.
Ordinal Utility Analysis
To measure the consumer behavior, we have seen how the
cardinal utility analysis comes to help which uses two measure based on utility
i.e., Total Utility and Marginal Utility. But in real life the utility i.e., satisfaction
can hardly be described in numbers. And even the consumers themselves would not
be measuring the utility in numbers. In real life consumer consumes multiple
goods but for the sake of simplicity to understand various concepts regarding
utility, we will take any two goods or commodity which we will assume that the
consumer is willing to buy. And we would
call that pair of good taken together (quantity of each individual does not
matter) a bundle. And let us take those two as Apple and Banana.
Indifference Curve
There can be several combination of different quantity of
Apple and Banana. And we also know that the several combinations of bundle can
presented diagrammatically via point plotted on a chart with Apple on one axis
and banana on the other. Now out of those different combinations, there will be
few bundles which will be giving equal utility or satisfaction to the consumer.
These points representing the bundles giving equal utility can be joined to
form a curve. This curve which represents all the points or bundles which would
give equal satisfaction or utility to the consumer making the consumer
indifferent between receiving or consuming any of those bundles is known as
Indifference Curve.
Let us understand the same with an example.
|
Bundles |
Bananas |
Apple |
|
A |
1 |
15 |
|
B |
2 |
12 |
|
C |
3 |
10 |
|
D |
4 |
9 |
As seen in the above chart graph, all the points including
A, B, C & D are lying on the Indifference curve showing that the consumer
is indifferent between receiving any bundle with combinations falling on the
curve as all those combinations will provide equal utility or satisfaction to
consumer.
Marginal Rate of Substitution
Now out of Apple and Banana, from
the several combinations, the bundle A has 15 Apples and 1 Banana. If the
consumer gets one more banana, some apples need to be forego in order to keep
the utility level same and be indifferent between the two bundles. Here in the
bundle B, to get 1 additional banana, while keeping the utility level equal, the
consumer will need to forego 3 apples. Thus this results in the indifference
curve sloping downward. The number of apples that the consumer needs to forego
in order to receive an additional banana in such a manner which keeps the level
of utility same or constant is termed as the Marginal Rate of Substitution. In simple
words, the Marginal Rate of Substitution refers to the rate at which the
consumer will substitute the bananas for apples keeping the total utility or
level of satisfaction same or constant.
The formula for the Marginal Rate of Substitution can be written as MRS =
Law of Diminishing Marginal Rate of Substitution
|
Bundles |
Bananas |
Apple |
MRS |
|
A |
1 |
15 |
NA |
|
B |
2 |
12 |
3:1 |
|
C |
3 |
10 |
2:1 |
|
D |
4 |
9 |
1:1 |
An important thing to note here is that, as the quantity of
bananas received is increasing, the number of apples that need to forego keeps
on decreasing. For bundle B, the number of Apples forgone for 2nd banana
is 3, for bundle C, for 3rd banana, number of apples foregone are 2
and for bundle D, for 4th banana, number of apples foregone is 1.
This shows that the Marginal Rate of Substitution decreases as the number of
bananas increase. But Why? Because as the number of bananas keeps on
increasing, the Marginal Utility derived from each additional banana keeps on
decreasing. At the same time, as the total number of apples keeps on
decreasing, the Marginal Utility derived from the remaining apples keeps increasing.
So with each additional increasing banana, the consumer will be motivated to
forego less number of apples per banana. This phenomenon in which the Marginal
Rate of Substitution keeps on diminishing with increasing quantity of bananas
is known as Law of Diminishing Marginal Rate of Substitution. So consumer will
be willing to forego smaller and smaller number or quantity of apples for each additional
banana.
Conclusion
In this session, we discussed the second important approach
to study the consumer behavior i.e., Ordinal Utility Analysis. Ordinal Utility
Analysis tries to overcome the basic flaw of Cardinal Utility Analysis which
tries to measure the utility in numeric terms where in real life, consumer don’t
measure satisfaction in numeric terms. So Ordinal Utility Analysis tries to
compare the utilities in form of bundles or different combination of a product
or commodity which can be at least ranked and can also be stated in a way where
the level of utility can remain the same across different bundles. This
resulted into forming of an Indifference curve where the consumer is indifferent
to any bundle of goods as long as the level of utility remains constant or
equal. Then finally we discussed the Marginal Rate of Substitution and Law of
Diminishing Marginal Rate of Substitution.
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