Utility Theory

What is utility?

Utility is the level of satisfaction a person derives from consuming a good or service. When the product or service is useful to the consumer’s needs or wants, they can achieve a certain level of utility from consuming it. In economics, there are two different types of utility: expected utility and subjective utility.

Expected utility

Expected utility is the utility that an economic agent is expected to reach in the future given several probable outcomes. Expected utility value is a probability concept used when several future outcomes are possible. It is calculated by multiplying each possible utility outcome by the probability of its occurrence and then adding them up. Expected utility theory deals with decision-making under uncertainty.

Subjective utility

Subjective utility is utility based on an individual's perceived level of satisfaction from consuming a good or service. Subjective utility is not based on market judgment. It is based on how attractive an individual perceives the benefit of using a good or service.

Utility theory

Students choose to study because they want to pass their exams. We eat something because we're hungry. We drive a car to reach a certain destination. We sleep to give our bodies some rest. Utility is involved in everything we do and we get satisfaction from consuming or using goods or services. This is what utility theory is concerned with: explaining individuals’ choices and measuring the satisfaction level from consuming a good or service.

The level of satisfaction is measured in units called ‘utils.’

Total utility and marginal utility

There are two different types of utility:

Marginal utility (MU)

Marginal utility is the satisfaction that a person receives from consuming an additional unit of the same good or service.

Total utility (TU)

Total utility is the aggregate satisfaction a person receives from the consumption of all the units of the same good or service.

Total utility is derived from adding every marginal utility from each additional unit.

The equation for total utility (TU) is:

$TU=MU-1+MU-2+MU-3+...MU-N$

Where MU-N is the marginal utility from consuming the N-th unit of a good.

Table 1. Relationship between marginal utility and total utility - StudySmarter.

As the table shows, the marginal utility decreases with the addition of further units, whereas the total utility increases until a certain point. At that point, which is 5 glasses of water, the total utility reaches its maximum and starts declining.

Figure 1 shows the relationship between marginal utility and total utility:

Fig. 1 - Relationship between marginal and total utility

We can conclude the following relationship between MU and TU:

• As the number of units increases, MU decreases, and TU increases.
• When TU reaches its maximum level, MU is 0. At that unit, the marginal utility is 0.
• MU starts to get negative and TU starts decreasing.

The law of diminishing marginal utility

Economists believe that the utility reduces as the consumption of the same product or service increases.

The Law of diminishing marginal utility states that the level of satisfaction for an individual diminishes as the use of the same product increases. Eventually, the consumer either looks for an alternative or stops consuming the product.

According to the law of diminishing marginal utility, the consumption of the first unit gives the consumer maximum utility. Then, the level of satisfaction starts reducing as the units increase. The consumer starts getting negative utility after a particular unit of consumption, which may vary from consumer to consumer.

Utility maximisation

Utility maximisation means that a consumer will try to get the highest level of satisfaction for consuming something they paid for. The utility may be different for every individual and cannot be stated as a single total unit.

However, even though consumers wish to have the maximum utility from the consumption of a product or service, sometimes they may have to make other choices due to constraints. Let's explore them:

Limited income

Even though someone may fancy having the best of all products because it gives them the highest satisfaction, limited income may stop them from buying it.

A given set of prices

Some individuals like some products or services more than others. However, they may opt for a substitute or a similar product due to the set of prices. Although they will get the maximum utility from consuming the high-priced goods, they may not be willing to pay the given set of prices. Thus, they will look for alternatives.

Budget constraints

Consumers’ choices are subject to their budget constraints. Budget refers to the total amount of money an individual is willing to spend, save, and borrow. Budget constraints can also be understood as limited income.

Limited time

Another constraint consumers may face while making choices is the availability of time.

The importance of margin when making choices

Economists say that most choices are made at the margin. The margin is the current state at which an individual is making choices. Margin helps the consumers decide how much they will gain or lose with the extra unit of a good or service. Hence, the consumer’s buying decision is on the margin.

Margin is important for these reasons:

• It is the point at which an individual decides whether to consume more or less.
• The margin determines the benefit that a consumer may receive by consuming an additional unit of a good or service. Therefore, it helps in deciding whether to consume additional units.
• Understanding consumers’ total marginal utility also lets the supplier decide whether the consumer will buy further goods or services.