To explain the concept and assumptions of ordinal utility analysis
Concept of Ordinal Utility Analysis
The theory of consumer behavior helps us to observe and predict consumers’ responses to changes in prices, income, tastes and preferences, price of related goods, and promotional expenditures. Understanding the consumer’s responses to changes in such variables helps managers to make rational decisions for the expansion of their business and share of the market. The ordinal utility or indifference curve technique is a modern and popular theory of consumer demand. Here we will discuss the concept and assumptions of ordinal utility analysis or indifference curve analysis.
The modern demand theory uses a logical slant to explain how the household decides concerning his/her economic choices and purchases. It is called the indifference curve analysis of ordinal utility analysis. The indifference curve approach was originally developed by Italian economist Vilfredo Pareto, who was the first economist to draw the indifference curve. Subsequently, it was fully developed by the British economists, JR Hicks and RGD Allen.
Indifference curve analysis has waved the idea of cardinal utility and has acknowledged the notion of ordinal utility analysis. Cardinal utility means that the utility that a consumer gets from a unit of a commodity can be measured in the exact amount. The utility derived from a commodity can be measured just as we can measure our height, length, weight, length, temperature, etc. Indifference curve analysis, on the other hand, is based on the idea of ordinal utility.
The term ordinal means ranking or ordering like first, second, and third. Thus, the ordinal utility analysis implies that the consumer is capable of simply comparing the utility that has derived from different goods or different units. It means ordinal utility does not require that the consumer should be in a position to measure the utility of different goods or different combinations of goods.
The ordinal approach to consumer utility states that utility/satisfaction cannot be measured in exact numbers but can only be ranked or put into order. This approach argues that utility/satisfaction is completely a psychological element and it cannot be expressed in cardinal numbers.
In ordinal utility analysis, an individual is observed to prefer one choice over others. Preferences can be well-ordered from utmost filling to tiniest filling. Only the ordering is important; the size of numerical values is not important except in as much as they establish the order.
For example, if a consumer prefers ice cream to chocolate, it is not required to say that the utility of 100 from ice cream is twice as desirable as a utility of 50 from chocolate. There is no need for a quantitative concept of utility in ordinal utility analysis.
An ordinal measure can be thought of as a list of high to low, good to bad, and top to bottom, and is often based on subjective/individual judgment of items. Ranking or ordering of utility makes relative comparison possible. Relative comparison means, for example, that the first is more than the second and the second is more than the third but how much more is not known. The ordinal utility approach is alternative and superior to the cardinal approach of utility analysis. The ordinal utility approach uses the indifference curve to analyze consumer behavior. Thus, has been also known as the indifference curve approach of utility analysis.
The notion of ordinal utility has been founded on the following axioms.
- A consumer can’t express his utility in the quantitative term. However, it is likely for him to express which of the two products he favors.
- A consumer can rank or list the entire merchandise he devours in the command of his partiality.
Assumptions of Ordinal Utility Analysis
According to P.A. Samuelson and William D. Nordhaus, ‘In ordinal utility approach, consumers need to determine only their preference ranking of bundles of commodities.’ In ordinal utility analysis, an individual is observed to prefer one choice to another. Preference can be ordered from most satisfying to least satisfying. Only the ordering is important; the size of the numerical values is not important except in as much as they establish the order. To understand indifference curves, it is best, to begin with, the assumptions. The indifference curve approach as a tool of the ordinal utility analysis is based on the following assumptions;
Rationality of Consumer
This analysis assumes the rational consumers whose objective is to maximize the utility under the budget constraint.
The utility is measured ordinally by comparing the satisfaction whether higher or lower by consuming different bundles of goods. It is sufficient that the consumer expresses his/her preference for the various bundles of goods and commodities. It is not obligatory to undertake that utility is quantitively quantifiable.
According to this assumption, when there are three goods A, B, and C, and if the consumer chooses as A > B, B > C, then A > C. It is acknowledged as transitivity in preference.
As per this assumption, the consumer remains consistent in choice. If there are two goods A and B then A is preferred over B i.e. A > B. At the same time, B cannot be preferred over A. i.e. B A. It is called consistency in choice.
The consumer always prefers moreover less if there is a choice available to him. It means the consumer has not reached to point of saturation in the case of any commodity such condition is called non-satiety.
Diminishing Marginal Rate of Substitution (DMRS)
Under this theory, the marginal rate of substitution between two goods always diminishes so that a consumer can attain the same level of satisfaction. It is given by ΔY/ΔX in the case of two goods X and Y and it tells the rate of substituting commodity X to get one more unit of commodity Y.
The ordinal utility approach to consumer utility analysis states that utility or satisfaction cannot be measured in exact numbers but can only be ranked or put into order. This approach argues that pleasure is completely a psychological element and cannot be expressed in numbers. In the technique of ordinal utility analysis, goods are only ranked in terms of more or less preferred but there is no attempt to determine how much more one good is preferred to another. The ordinal utility can reflect an order only. The ordinal utility theory of consumer behavior is usually called indifference curve analysis as indifference curves are its main analytical tool. Here we have discussed the concept and assumptions of ordinal utility analysis in brief.
References and Suggesting Readings
Ahuja, H.L. (2017). Advance Economic Theory. New Delhi: S. Chand & Company.
Dhakal, R. (2019). Microeconomics for Business. Kathmandu: Samjahan Publication Pvt. Ltd.
Dwivedi, D. N. (2018). Microeconomics Theory and Application. New Delhi: Vikas Publishing House PVT LTD
Kanel, N.R. and et. al. (2019). Microeconomics for Business. Kathmandu: Buddha Publications.
Shrestha, P.P. and et. al. (2019). Microeconomics for Business. Kathmandu: Advance Saraswati Prakashan.