Cardinal vs.

Ordinal Utility Theory

Cardinal Utility Theory
Based on assumption that one can convert units of consumption into units of utility. Problem: What is a unit of utility?

Ordinal Utility Theory

Based on assumption that one can rank order two bundles of goods, A and B.
i.e., A preferred B, B preferred A, or equally satisfying.

Utility Concepts
Utility: satisfaction received from consuming goods Cardinal utility: satisfaction levels that can be measured or specified with numbers (units = utils) Ordinal utility: satisfaction levels that can be ordered or ranked Marginal utility: the additional utility received per unit of additional unit of an item consumed (U/ X)

Utility Assumptions
1. Complete (or continuous) can rank all bundles of goods 2. Consistent (or transitive) preference orderings are logical and consistent 3. Consumptive (nonsatiation) more of a normal good is preferred to less

Definition of Indifference Curve

The various combinations of the two goods (X and Y) which give the same level of satisfaction.

Indifference Curve
Indifference Curve A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction. Curves further from origin represent higher utility levels

PROPERTIES of INDIFFERENCE CURVES:

Indifference curve slopes downwards Indifference curve is convex to the origin Indifference curves do not intersect each other Higher Indifference curve shows higher level of utility.

Indifference Curve is based on the following axioms:

Axiom of completeness Axiom of transitivity Axiom of non-satiation

Axiom of Completeness
Completeness
Any two bundles of goods (A and B) can be compared. (A P B) or (B P A) or (A I B)

There are no bundles which cannot be compared.

Axiom of Completeness
This says that any bundle is on some indifference curve.
Y

Axiom of Transitivity
This simply says preferences make sense. Specifically:
If (A P B) and (B P C) then: C) (A P

Axiom of Transitivity
This implies indifference curves cannot cross. Proof by contradiction
A indifferent to B due to being on same indifference curve. A indifferent to C due to being on same indifference curve. Thus, B is indifferent to C by transitivity. But this violates nonsatiation since B has same X and more Y than C.
Two ICs can never intersect. Y

B A C

U2
U1 X

Axiom of Nonsatiation (More is better)

This says that if we are examining, that more of the good is preferred to less of the good.

Axiom of Nonsatiation
This says that satisfaction goes up as you move to higher (i.e., to the northeast) indifference curves. This is because as you move to the northeast, you get more of both goods (e.g., moving from point B1 to B2 gives more CDs and more Movies)
Y

U1 <U2 <U3
B A

U3 U2 U1

More of a Good is Preferred to Less

The shaded area represents those combinations of X and Y that are unambiguously preferred to the combination X*, Y*. Ceteris paribus, individuals prefer more of any good rather than less. Combinations identified by ? involve ambiguous changes in welfare since they contain more of one good and less of the other.

What is the slope?

Marginal Rate of Substitution (MRS)
The tradeoff between X and Y that is just necessary to make the individual indifferent between the two bundles.

Derive Slope Mathematically

Now, U=U(X,Y) Total differentiation of the above equation gives us: U= (U/ X) dX + (U/ Y) dY where MUX= U/X or marginal utility of an added unit of X and MUy= U/Y or marginal utility of an added unit of Y .

Along an indifference curve all the commodity bundles give the same level of utility so U=0
(U/ X) dX + (U / Y) dY = 0

-dy/dx = (U/ X) / (U/ Y)

MRS = MUX / MUy

Slope of the Indifference Curve= -dy/dx = MRS = MUx/ MUy

MRS graphically
Y

A B

MRS is simply the slope of the indifference curve. Notice slope is not constant.
X

Diminishing MRS
Y

A B C
D

At A, youre Y rich and X poor.

Willing to sacrifice lots of Ys for extra X

At C, youre X rich and Y poor.

X
Willing to sacrifice few Y for extra X.

The IC is convex to the origin due to Diminishing MRS which is again due to diminishing MU.

Some Unique Preferences

Perfect Complements
Left Shoe U2 >U1 U2 >U1 U2 U1 Right Shoe

Perfect Substitutes
Coke

U1
U2 Pepsi

Increasing MRS
Good Y U2 >U1

U2

U1
Good X

Risk/return:
- Indifference curves can also be used as a representation of an individual's feelings about risk and return . - A person who is risk neutral (doesn't care about risk) will have horizontal indifference curves in the return-risk space - A person who is risk averse will have positively sloped indifference curves; more return must be provided to the person to compensate for additional risk - If a person is "increasingly risk averse", the indifference curves will be positively sloped and convex (from below) curves

A. Risk neutrality:
average return

u3 u2 u1

risk

B. Risk aversion:
Average return
u3 u2 u1

risk

C. Increasing risk aversion:

average return

u3 u2 u1

risk

BUDGET CONSTRAINT:
The locus of all bundles of goods that can be purchased at given prices if the entire money income is spent.

Budget Constraint Variables

M= the amount of income or money that a consumer has to spend on specified goods and services.
the quantity of one specific good or one specific bundle of goods the quantity of a second specific good or second specific bundle of goods the price or per unit cost of X the price or per unit cost of Y

X = Y = Px = PY=

Budget Line Equation

Income = expenses M = PxX+PYY Y = M/PY (Px/PY)X straight line equation

Budget Line: Axis Intercepts & Slope

Vertical Axis Intercept = M/PY = max Y (X = 0) Horizontal Axis Intercept = M/PX = max X (Y = 0) - Slope = PX/PY

The Opportunity Set

M/Py -Px/Py

M/Px

Changes in the Budget Line

Changes in Income - Increases lead to a parallel,
outward shift in the budget line. Decreases lead to a parallel, Y downward shift.

Changes in the Budget Line

Changes in Price - A decrease in the price of good X rotates the budget line counter-clockwise. - An increase rotates the budget line clockwise.
Y New budget line for a price decrease

I / Px

I / Px2

Consumer Equilibrium (U Max)

The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction.

Equal Slopes Condition (for consumer equilibrium)

MUX/MUY = PX/PY MUX/PX = MUY/PY

Income and Substitution Effects of a Price Change (for normal goods)

Price of a good or service FALLS Opportunity cost of the good falls Household is worse off (lower real income) RISES Opportunity cost of the good rises. Substitution effect Household buys less Substitution effect Household buys more Household is better off (higher real income) Income effect Household buys more

Income effect

Household buys less

Consumer surplus:
idea of purposive behavior underlying the demand curve naturally links to the idea of the demand curve as an indication of an individual's willingness-to-pay for the goods - The difference between an individual's willingness-topay and the price that he/she actually pays is a measure of consumer surplus; in graphical terms, it is the area under the demand curve and above the price that is actually paid; for a straight-line demand curve, consumer surplus would have the area of the triangle below the demand curve and above the price line.
- The

Suppose that widgets are bought only as single units, or not at all; i.e., an individual either buys one widget during a year, or doesn't buy any. Suppose further that there are different preferences (willingnesses to pay) among individuals. For example, Mr. A would be willing to pay up to Rs.10 (but no more) for one (and only one) widget, Ms. B would be willing to pay up to Rs.9 for one (and only one) widget, Ms. C would be willing to pay up to Rs.8, etc. These willingnesses to pay would constitute a demand curve that would look like Figure 1 below. If the market price is Rs.6.00 then Mr. A "enjoys" the difference between his maximum willingness to pay of Rs.10 and the actual price of Rs.6; this can be described as a "consumer surplus" for Mr. A of Rs. 4 (Rs.10 - Rs.6); Ms. B enjoys a consumer surplus of Rs.3, etc. Consumers A-E have willingnesses to pay that exceed the price, and they buy the good; five widgets are bought/sold. The aggregate consumer surplus (CS) -- the area below the demand curve and above the price line -- is Rs. 10 (Rs.4+3+2+1+0). If the market price instead is Rs.3.00 then Mr. A enjoys a consumer surplus of Rs.7 (Rs.10-Rs.3), etc. Consumers A-H have willingnesses to pay that exceed that price; eight widgets are bought/sold. The aggregate consumer surplus (CS) is Rs.28 (Rs. 7+6+5+...) If there are many more consumers with smaller differences in their willingnesses to pay, the demand curve becomes a smoother line; aggregate consumer surplus is still the area below the demand curve and above the price line; for a straight line demand curve, the aggregate consumer surplus (CS) is a triangle, as in Figure 2.

P
10 9 8 7 6 5 4 3 2

Mr. A Mr. B Mr. C

AGGREGATE CS when P=Rs.6 AGGREGATE CS when P=Rs.3

P
CS when p=p

P* P**

CS when p=p

**

Q
Figure 1: Discrete demand

q*

q**

Figure 2:Continuous demand