Ordinal Utility Theory

4. The Ordinal Approach in Utility Theory

Ordinal utility is a view of utility measurement based on the presumption that the satisfaction of wants and needs is not a quantifiable characteristic of human activity and that preferences are subjective. Preferences among goods can be ranked (first, second, third, etc.) but not measured according to a scale. In this regard, consumers need only specify whether one good is more or less preferred than another. How much more or less a good is preferred is not important.

The ordinal ranking of preferences provides a solid theoretical basis for the analysis of market demand and the law of demand using modern indifference curve analysis. Ordinal utility applies this ranking to preferences. In the modern

It is one of the theoretical conclusions of the deduction process. The equilibrium points A, B and C in Fig 4.4 show the optimum quantities demanded of a consumer faced with different price levels, ceteris paribus. The change in prices is expressed by the rotation of the budget line. The demand curve derived represents the different states of utility maximization of a consumer when price changes.

4.3 Price Consumption Curve (P.C.C.)

(1) It is the locus of points of contact between the indifference curve and the changing (relative price) budget line, when the budget line rotates from a point on the vertical axis (due to a change in the price of the good represented by the horizontal axis).

(2) The curvature of the P.C.C. helps to determine the value of the price elasticity of demand, thus describing the degree of response of a consumer on price changes. (3) When price changes, the P.C.C. also shows the quantity demanded of the other good on the y axis, thus the cross elasticity of demand can be obtained. The P.C.C. tells the relation between any two goods with price changes. It is likely to slope downward first and upward later and unlikely to bend backward in

But if we are dealing with a good that comprises only a small percentage of the consumer’s budget, an increase in the price of this good will has an insignificant effect on the consumer’s real income. In such a case, the negligible negative income effect will do little to offset the negative substitution effect

4.6.3 Income & Substitution Effects of a Giffen Good

The substitution effect will not be influenced by the percentage of income spent on the good. Therefore, to be a Giffen good, a good must be an inferior good on which the consumer spends a major percentage of his or her income. This leads us to conclude that the Giffen paradox may apply only to very poor consumers (only a poor consumer would spend a large proportion of income on an inferior good). This is the reasoning behind what economists most commonly accept as a plausible example of a Giffen