Consumer Theory - Ordinal Approach

DEPARTMENT OF MANAGEMENT STUDIES
Subject code: MS-5103

Managerial Economics
Course Contents:
Demand and Supply analysis✔
Utility: Cardinal utility✔
Consumer Theory (ordinal utility)
Production and cost analysis
Theory of markets and pricing strategies

❖Perfect competition
❖Monopoly
❖Monopolistic competition
❖Oligopoly
Consumer Theory
(Ordinal Utility Approach)
Indifference Curves
Budget Constraint
Equilibrium
Price Consumption Curve

Consumer Preference- Indifference Curve
•Meaning
•Assumptions of Indifference Curve approach
•Indifference Map
•Marginal Rate of Substitution (MRS)
•Properties of Indifference Curve

Indifference Curve
Meaning
•Locus of points depicting combinations of goods providing the

same level of satisfaction (Assuming two goods in the bundle)
Indifference Map
•Collection of Various indifference curves
•Used to rank preferences
•Any point lying on a particular IC will give same level of satisfaction
•Points lying on higher ICs represent higher level of satisfaction
•Higher ICs are preferred over lower ICs

Indifference Curve
Assumptions
•Consumer is assumed to be rational
•Utility is assumed to be ordinal
•Consistency of choice
•Transitivity of choice
Indifference Curve
Marginal Rate of Substitution
•Marginal Rate of Substitution X for Y is the amount of Y given up to

gain one extra unit of X, keeping the satisfaction level or utility
constant.
•MRSxy=-dY/dX=-MUx/MUy
•It is the slope of the Indifference curve- defined as the ratio of

marginal utilities of good X and good Y
Indifference Curve
Properties
•An indifference curve has a negative slope
•A higher indifference curve is always preferred to a lower one
•Indifference curves do not intersect with each other
•Indifference curve is convex to the origin- Diminishing Marginal

Rate of Substitution
Consumer Theory
Indifference Curves✔
Budget Constraint
Equilibrium

Consumer Constraint- Budget
•Budget Line: Slope and Intercept
•Budget Space
•Shifts in the budget line

Budget Constraint
•Two constraints of consumer:
❖Prices of the goods- Market price that the consumer has to pay for
procuring those goods
❖Money income of the consumer- Limited money income with which

he will pay for the goods
Budget Constraint
Budget line: Slope and Intercept
•Budget line- the locus of combinations of two goods that a

consumer can afford at the given market prices if he spends all his
money income
Budget line equation: M=Px X + Py Y
Intercepts of the budget line:

X intercept: M/Px
Y intercept: M/ Py
Slope of the budget line: -Px/Py

Budget Constraint
Budget Space
•Set of al commodity combinations that can be purchased by

spending whole or part of the given income of the consumer
•All the combinations of commodities X and Y that the consumer

can afford for which income spent on the goods must be less
than or equal to the given money income
Budget space equation: M ≥ Px X + Py Y
•Graphically it is the entire area enclosed

by the budget line and the two axes.
Budget Constraint
Shifts in the Budget line
•Shifts in the budget line results from two factors:
Changes in the prices of goods
Changes in the money income

Budget Constraint
•Change in price of good X: Increase or decrease
We have:
X intercept: M/Px
Y intercept: M/ Py
Increase in the price Decrease in the price

of X: of X:
M/Px reduces- X M/Px increases- X
intercept decreases intercept increases
M/ Py remains the M/ Py remains the
same- Y intercept same- Y intercept
same same
-Px/Py increases- -Px/Py decreases-
slope increases slope decreases
Budget Constraint
•Change in price of good Y: Increase or decrease
We have:
X intercept: M/Px
Y intercept: M/ Py
Increase in the price Decrease in the price

of Y: of Y:
M/Px same- X M/Px same- X
intercept same intercept same
M/ Py decreases- Y M/ Py increases- Y
intercept decreases intercept increases
-Px/Py decreases- -Px/Py increases-
slope decreases slope increases
Budget Constraint
•Change in income of the consumer: Increase or decrease
We have:
X intercept: M/Px
Y intercept: M/ Py
Increase in consumer Decrease in

income M: consumer income M:
M/Px increases- X M/Px decreases- X
intercept increases intercept decreases
M/ Py increases- Y M/ Py decreases- Y
intercept increases intercept decreases
-Px/Py same- slope -Px/Py same- slope
same same
Consumer Theory
Budget Constraint ✔
Equilibrium

Consumer Equilibrium
•A consumer is in equilibrium when he derives maximum
satisfaction, given his constraints
•Graphically consumer equilibrium is derived at the tangency

of budget line and the highest attainable indifference curve
•Mathematically, consumer is in equilibrium where the slope

of budget line equals the slope of indifference curve
MUx/MUy = Px/Py
Consumer Theory
Budget Constraint ✔
Equilibrium ✔

•A graph showing how a consumer’s consumption choices change

when price of one of the goods changes
•Plotted by connecting the points at which the budget line

touches the relevant maximum utility indifference curve
Derivation of demand curve
from PCC
Practice Questions
Question :
Mr. A has Rs 1500 to spend for Sandwich and coffee at a
cafeteria. A cup of coffee costs Rs 160 and a sandwich
costs Rs. 85.
Write the equation for Mr. A’s Budget line and depict this
in a graph. How many cups of coffee can he afford if he
spends his entire money on coffee?
Question:
The budget constraint of a consumer is given as:
160=4x+5y
Draw the budget line and find its intercepts and the
slope.
Describe how the shifts in the budget line will take place
when:
i) Price of x rises to Rs 8.
ii) Price of y falls to Rs. 2
iii) Price of x is Rs 4, price of y is Rs 5 and income of the
consumer is Rs. 240.
Draw the changes in the budget line and determine the
intercepts and the slope in each case.

Consumer Theory - Ordinal Approach

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DEPARTMENT OF MANAGEMENT STUDIES

Subject code: MS-5103

Demand and Supply analysis✔

Utility: Cardinal utility✔

Consumer Theory (ordinal utility)

Production and cost analysis

Theory of markets and pricing strategies

Price Consumption Curve

•Assumptions of Indifference Curve approach

•Marginal Rate of Substitution (MRS)

•Properties of Indifference Curve

•Locus of points depicting combinations of goods providing the

•Collection of Various indifference curves

•Used to rank preferences

•Any point lying on a particular IC will give same level of satisfaction

•Points lying on higher ICs represent higher level of satisfaction

•Higher ICs are preferred over lower ICs

•Consumer is assumed to be rational

•Utility is assumed to be ordinal

•Marginal Rate of Substitution X for Y is the amount of Y given up to

•It is the slope of the Indifference curve- defined as the ratio of

•An indifference curve has a negative slope

•A higher indifference curve is always preferred to a lower one

•Indifference curves do not intersect with each other

•Indifference curve is convex to the origin- Diminishing Marginal

Price Consumption Curve

•Budget Line: Slope and Intercept

•Shifts in the budget line

•Two constraints of consumer:

❖Money income of the consumer- Limited money income with which

•Budget line- the locus of combinations of two goods that a

Budget line equation: M=Px X + Py Y

Intercepts of the budget line:

Slope of the budget line: -Px/Py

•Set of al commodity combinations that can be purchased by

•All the combinations of commodities X and Y that the consumer

Budget space equation: M ≥ Px X + Py Y

•Graphically it is the entire area enclosed

•Shifts in the budget line results from two factors:

Changes in the prices of goods

Changes in the money income

•Change in price of good X: Increase or decrease

Increase in the price Decrease in the price

•Change in price of good Y: Increase or decrease

Increase in the price Decrease in the price

•Change in income of the consumer: Increase or decrease

Increase in consumer Decrease in

Price Consumption Curve

•Graphically consumer equilibrium is derived at the tangency

•Mathematically, consumer is in equilibrium where the slope

Price Consumption Curve

•A graph showing how a consumer’s consumption choices change

•Plotted by connecting the points at which the budget line

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