Modern Consumer Theory:

Ordinal Utility, Preferences and

Indifference Curves
Significance: Dispenses entirely with concept of “utility” and
depends only on observable quantities
Learn:
• Assumptions about consumer’s behavior
• Properties of indifference curves
• Representing the consumer’s budget constraint
• Equilibrium Condition and how consumer gets there.
• How to represent changes in prices or income
• Constructing the demand curve from indifference map
• How to decompose a change in purchases into substitution
and income effects
• Definition and illustration of indexation
• Consumer wishes to choose between
alternate “market baskets” of goods
• Assumptions:
– Consumer knows own preferences: for any
baskets A and B, A P B, B P A, or A I B
– Transitivity: if A P B and B P C, then A P C
(or I)
III. For any good, more is better than less
IV. Variety in consumption: a market basket
with some X and some Y is preferred to all
X or all Y
Y

 B

A F

C D

X
 Indifference Curves:
Y

B

A
F

C D II
I

Since F P C every point on II must be preferred to every

point on I ⇒ points on curves to right are preferred to points
on curves to left.
Shape: reflects assumption IV above.
 Non-Intersection Property

A  B

C

Since B P A and B I C, we must have C P A, but C

and A are on same indifference curve, a logical
contradiction.
• Marginal rate of substitution of X for Y: slope of the indifference
curve or |∆Y/ ∆X|
• MRSXY is the rate at which consumer is willing to give up Y for
additional X
Y

∆Y

∆X
• The Budget Constraint depends on
– prices
– how much the consumer has to spend

Slope of the Budget

B/pY Constraint is the price ratio
–pX/pY. The absolute value
px/py is called the marginal
rate of exchange

X
B/pX
• Marginal Rate of Exchange of X for Y: The
absolute value of the slope of the budget line.
MREXY gives the terms on which the consumer
can exchange Y for X.
• To buy an extra X, consumer must reduce
purchases of Y by pX/pY.
• Or, giving up one Y allows the consumer to
obtain px/py of X
• Example: suppose pV = $2 and pB = $3 and
consumer has $18. Max videotapes = 9 and
max beer = 6. Slope = 9/6 = 3/2 = 1.5. Sandy
must give up 1.5 videotapes to get an additional
6-pack.
 V Suppose that Sandy
initially finds herself at this
9 position. Note that
MRSXY > MREXY

The slope of the budget

line = rise/run. In rising
nine Y, the line runs -6
X.

B
6
 B
To obtain ∆X, consumer is
willing to give up ∆Y. He has
to give up only dY however, so
moving to the right along B-B
dY is a bargain.
∆Y Consumer need only know
that he’s willing to give up
more Y than he has to.

∆X
 V

Consumer is in equilibrium at
9 E, where MRSXY = MREXY. At
any other point on budget
line, consumer will find his
willingness and ability are not
equal. Above E, he’ll give up
more Y to get X than he has
to. Below E, he’ll give up
E more X to get Y than he has
to.

B
6
 V At equilibrium, we have
MRSXY = pX/pY. Since
9
MRSXY is roughly
equivalent to MUX/MUY, this
is equivalent to condition
found in equilbrium with
cardinal utility.

B
6
 EXAM THURSDAY
• Coverage as noted in Syllabus
• Study Questions Sets 2, 3 & 4 through question
23
• Newspaper readings as posted
• Format and length as first exam
• Bring
– number 2 pencil
– calculator (NOT cell ‘phone)
• Bubble in your name Last Name First Name
• I will use PIN from first exam; there’s no reason
to repeat it
 V

Establishing Demand
Curves: When the price
B of beer falls from $3 to
$2, the budget line
rotates from B-B to B-B’.
Sandy’s purchases
increase from 4 to 6

II
I

B
4 6 B B’
Sandy’s demand for beer can be established by presenting him
with different prices and observing how much he buys. The
points 3,4 and 2,6 are two points on his demand curve D-D.

Price of Beer

D
3 •

2 •

D
Quantity of Beer
4 6
 V

Establishing Income
9 Effects: When Sandy’s
Budget increases from
$18 to $24, his
purchases of both goods
increase.

II
I

B
4 5
• Demand: when p, q
– substitution effect
– income effect
• How much of change in q is due to which
• Decomposing change into substitution and
income effects
• In principle
– Observe change as price rises
– Restore original income and observe new
purchase; any difference must be substitution
effect
 Decomposing Substitution and Income
V Effects: The Hicks Decomposition.

H “Same income” is defined as being on the

same indifference curve. E is the original
consumer equilibrium; E’ is the
B equilibrium after price increase.
Giving the consumer
additional income creates the
budget line H-H; the
“compensated” equilibrium is
at EH.
EH
E’
The substitution effect
E is 1 or 7 – 6; the
income effect is 2 or
II
6 – 4.
I
H B
4 B’ 6 7 B
 Hicks Decomposition in reverse:
Y When the price of X falls, budget
line rotates to B-B’ and consumer’s
purchases increase from 4 to 8.
B The line H-H reduces income back
to the original indifference curve
but with new price ratio.

II

H X
4 6 B 8 B’
Sir John Hicks, 1904 – 1989
Hicks was said to be mystified by the
difference in treatment accorded himself
vs. John Maynard Keynes. Keynes was a
public figure, widely known for his
economic theory and praised for the
elegance of his writing. On top of that,
Keynes was wealthy and even married a
Russian ballerina, an exotic beauty, while
Hicks got by with a professor’s salary and
a frumpy, dowdy professor’s wife.
The fact is – Keynes was oriented to
policy and reveled in public attention,
while Hicks was an “economist’s
economist” who wrote for other
professionals. Of the two, Hicks surely
made the greater and more lasting
contribution to economic theory. But
Keynes had a far greater impact on
political and social thought.
• Example: Suppose that the U.S. levied a
tax of $3 a gallon on gasoline while
simultaneously cutting income taxes, so
that tax revenues remained constant – in
effect compensating consumers by giving
them more money.
– What would happen to sales of gasoline?
– Would anyone be worse off?
• Definition of “real income”
• Hicks: same indifference curve. Interpreted as same
level of utility
• Slutsky: enough money to buy same market basket
 Decomposing Substitution and Income
V
Effects: The Slutsky Decomposition.
S The consumer is compensated for higher
prices by giving him enough additional
money to buy the original market basket.
B But he will instead buy ES.

The original equilbrium is at E;

when PB rises, consumer
moves to E’. The line S-S
represents new price ratio with
ES
E’ enough money to buy E.

E Compensated
III equilibrium is at
ES .
I II
S B
4 B’ 6 7 B
• Advantage of Slutsky approach: involves
observable quantities.
• Led to statistical estimation of societal
indifference curves.
• Note: after being compensated in the
Slutsky manner is consumer as well off or
better off?
Eugene Slutsky, 1880 –
1948. Slutsky was Russian,
but his path-breaking paper
was published in Italian, a
language little spoken in
Britain or the United States.
The paper was discovered,
and Slutsky rescued from
obscurity, by Paul
Samuelson in the 1930’s.
• Indexation: The process of tying a payment or
other value to a price index, increasing the value
at the same rate as the price index. (Also called
a “Cost of Living Adjustment” or COLA.)
– Social Security payments are indexed by the
Consumer Price Index
– Personal Exemption in federal income tax is indexed
• Social Security is similar to Slutsky
decomposition: if cost of market basket
increases 10%, Granny gets 10% more dollars –
enough to buy original market basket
– But Granny won’t
• Conclusion: indexation makes Granny better off
year-to-year