Ordinal utility
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Ordinal utility theory states that while the utility of a particular good and service cannot be measured using an objective scale, a consumer is capable of ranking different alternatives available. Goods are often considered in ‘bundles’ or ‘baskets’. For example, does individual A prefer 3 apples and 2 oranges or 3 oranges and 2 apples? When a large number of baskets of goods are compared, the preferences of the individual can be seen. This information is usually put together on a graph called an indifference map. One of these is shown below:
Each indifference curve represents combinations of two goods or services which give the same level of utility to the consumer. The further a curve from the origin, the greater the level of utility. The slope of the curve (the marginal rate of substitution of X for Y – MRSxy) shows the rate at which the individual trades off good X against good Y. The curve is convex to the origin due to diminishing marginal utility. The usual assumptions about a rational economic human have to hold for the indifference curve approach to work. It can also be shown that indifference curves (an ordinal approach) give the same results as cardinal utility theory i.e. consumers will consume until the ratios between the marginal utility and the prices of all goods and services will be equal (the equi-marginal principle).
Another entirely different problem is whether ordinal utility is indeed an observable variable in real world. For example, in closed hypothetical system like above, there are only orange and apple to choose from. Therefore, when an individual choose orange, one can definitely say that an orange is preferred over an apple. However, in real world, when a consumer purchases an orange, it is often impossible to say what good or set of goods or collection of behavioural choice (including not purchasing anything at all or doing something else) were discarded as options.[1][2][3]
