What is Utility?

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Definition:

Utility is an economic term that measures the total value or satisfaction that a consumer derives from purchasing and using a service or product.

🤔 Understanding utility

People typically buy things because they need them or will enjoy having and using them. While it’s difficult to assign a specific value to the satisfaction you get from a product, assigning that value is essential in the world of microeconomics. Utility refers to the total satisfaction or value that you get from consuming a particular product or service. Utility values are critical for determining why different goods have different costs and levels of demand. Products with higher utility usually have more demand, meaning they can command higher prices.

Example

People need to eat food to survive, but some foods are better than others. A packet of instant ramen does not taste as good or provide the same nutrition as a home-cooked meal does. Economists may assign, say, one unit of utility to a pack of instant ramen and three units of utility to a home-cooked meal based on the difference in the satisfaction that the eater receives from each meal. The different values help explain why instant ramen usually has less demand and is cheaper than a home-cooked meal.

Takeaway

Utility is like a group of emojis ranging from happy to sad…

Different products or items can make someone happy or sad, and can make them happy or sad to different extents. The happier they make someone (the bigger the smile on the emoji), the more utility they provide. For example, you might really enjoy an action movie, find a comedy to be kind of fun, and dislike horror movies. Each movie offers different amounts of utility.

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What is utility?

Utility is an economic theory that measures the value, happiness, or satisfaction that someone gets from consuming a product or service. People tend to purchase things because they want or need those things. Utility measures how much value those purchases provide.

Utility is a significant concept in economics because it helps explain many aspects of supply, demand, and pricing.

Items that provide more value tend to have a larger market because they offer more satisfaction to consumers. Higher levels of demand typically lead, in turn, to higher prices.

Understanding the pleasure that different products provide can help economists understand why various goods command different prices.

Utility can be very different for different types of products. For example, various food items might have different values because of the difference in the nutrition they provide. More nutritious foods often satisfy more of a consumer’s need for food. At the same time, tastier meals, even if they’re less healthy, may gain utility because they satisfy a want for food that tastes good.

Things like art or other household decorations don’t have value because they meet needs but because they satisfy desires, like the desire to own something beautiful.

Utility expresses an economic concept that has a basis in reality, but cannot measure the absolute value that a product provides. There’s no way to say that, for example, a cheeseburger offers 2 units of utility, and a hamburger offers 1 unit of utility.

The amount of satisfaction that an individual gets from any item can vary with a multitude of factors. The general tastes of a particular consumer, whether they’re hungry at the time, and the quality of the ingredients used can all affect the satisfaction they receive.

Because economists cannot assign objectively accurate values to products or services, they use utility as a concept to explain economic phenomena. For example, if food prepared at a sit-down restaurant commands higher prices than fast food, it stands to reason that restaurant meals offer more satisfaction.

In some cases, a good or service can offer negative satisfaction to a consumer. Someone who is allergic to nuts won’t derive any value from eating pasta with an herb and nut pesto. Instead of satisfying a need, the pasta offers negative utility to the allergic consumer.

What are some examples of utility?

One example of utility is the nutrition that you get when you eat food. People need food and water to survive, but some food and water are of higher quality than others.

Drinking purified water offers more utility than drinking dirty water because it satisfies your thirst without the potential to get you sick. A freshly cooked meal provides more value than a frozen, microwaved meal because it is more nutritious and generally tastes better.

Products that don’t satisfy a physical need can also offer utility. For example, a piece of art that someone uses to decorate their home satisfies a desire for a home that looks good.

The same product can offer different levels of satisfaction to different consumers. Someone who enjoys playing video games will get more utility from a new game than someone who prefers board games.

What is the utility theory in economics?

In economics, utility theory tries to explain the behavior of individual consumers in an economy. Utility theory argues that each person, given a list of options, can rank those options in a precise order of preference. Each person has different choices which are set, not changing over time.

For example, imagine consumer A consistently prefers hamburgers to hot dogs, while consumer B always wants a hot dog more than a burger.

Utility theory relies on a few assumptions about consumers and their behavior: One assumption is that people can rank any number of options in exact order of preference. The options need not be related, and there is no limit to the number of options that the consumer can rank.

A second assumption is that more total utility is always better. If Bundle A produces 10 units of utility, and Bundle B produces 11 units of utility, the individual will always be better off with Bundle B.

Utility theory also assumes that a mix of goods is better. If a consumer values two items roughly equally, then a combination of the two offers more expected utility. For example, a consumer who considers hot dogs and hamburgers roughly equal would choose to receive one of each over two hotdogs or two hamburgers.

Finally, utility theory relies on rational decision making. If a consumer prefers product X to product Y and product Y to product Z, then there is no time that the decision-maker will prefer product Z to product X. In other words, the individual’s preferences are fixed and don’t change.

Utility theory can explain why consumers behave the way they do and make the purchases they make.

Expected utility theory is a related theory. It states that consumers make decisions based on the satisfaction they can expect to receive from an action, even when outcomes are uncertain.

What are the characteristics of utility?

Four characteristics of utility are form, time, place, and possession.

Form utility is the value that an item has based on the form that it takes. Individual car parts have value, but when someone assembles them into a functional vehicle, the utility the car offers is higher than the utility offered by each of its parts alone.

Time utility is the satisfaction that a product offers to a consumer based on when they receive the product. A hungry consumer receives more pleasure from food than someone who just ate. If a consumer never encounters a product, even if it’s high quality, they never receive its utility.

Place utility is the value that a product offers based on where the product is. If you’re hiking, a hiking backpack provides significant utility. If you’re trying to bring your books to school, a hiking backpack works, but isn’t quite as useful, offering less value. If you’re staying at home for the next few weeks, the bag provides much less utility.

Possession utility describes the utility that something offers based on who has that item. A DVD in a store has value, but it doesn’t provide as much value as it would if it were in a consumer’s DVD player, letting a group of people watch the movie. The DVD offers additional utility because someone who will use it possesses it.

What is ordinal utility?

When using ordinal utility, consumers assign preferences, but not values, to different products.

For example, someone might say they prefer action films to comedies and comedies to dramas, but they won’t say those action movies are worth 5 points of utility, comedies worth 4, and dramas worth 1.

Some economists argue that ordinal utility is a more realistic way to look at utility theory. Most consumers don’t have a scoring system that they use to make decisions about what to buy. They simply know their preferences and make decisions based on these feelings.

What is cardinal utility?

Cardinal utility assumes that people can assign specific values to products and use those values to make a decision.

For example, a consumer can determine that they receive precisely 20 points of utility from a ticket to a baseball game and 30 points of satisfaction from seats at a hockey game. Thus, the consumer always prefers hockey tickets to baseball tickets, assuming comparable prices.

Cardinal utility is part of rational choice theory, which argues that people work to achieve utility maximization.

One way that economists try to assign utility values to products is by looking at the maximum price a consumer will pay for a product. If someone is willing to pay $50 for a hockey ticket, they may decide that they receive 50 units of utility from it. If they would only pay $30 for a baseball ticket, they only get 30 units of satisfaction from seeing a baseball game.

Cardinal utility is also crucial for the efficient allocation of goods and welfare economics. An economy reaches allocative efficiency when marginal cost (the cost of each additional good) and marginal utility (the value of each additional good) are equal.

What is total utility?

Total utility is the complete level of satisfaction or value that a person receives from consuming a specific product. This contrasts with marginal utility, which is the value that someone gets from using an additional unit of a product.

This is important because of the law of diminishing marginal utility. The law states that the more units of a product consumed, the less value each offers. For example, eating one taco might offer 10 units of satisfaction, but two tacos only provide 19 units of total utility. Three tacos provide 27 units of utility, four offer 34, and so on.

Each new taco consumed offers one less unit of utility than the previous one. The marginal utility of an additional unit of a product can be negative. Someone who continues eating tacos will eventually make themselves sick.

The total satisfaction increases as consumption increases until more units offer negative utility. When that happens, additional consumption reduces overall utility.

How do you calculate utility?

Utility relies on assumptions for the value that a product provides, so you cannot calculate an exact, objective value for utility. Instead, you can calculate total and marginal utility using different theories to assign value to a product.

For example, when you work with cardinal utility, one way to assign a value is to make the satisfaction gained equal to the maximum price a consumer will pay for a good.

To calculate total utility, find the sum of marginal utility for every unit consumed.

To find the average utility provided by each unit of a product, divide the total value by the number of units consumed.

Why is utility important?

The utility function is essential because it relates heavily to the law of supply and demand and helps explain consumer behavior through decision theory.

Rational consumers purchase things because those goods offer some form of value to them. Consumers create demand for goods because those goods provide utility. The higher the satisfaction offered by a good, the more consumers will demand that product.

Increased demand often leads to higher prices, which creates an incentive for businesses to produce that good. As supply increases, prices tend to drop. Over time, cost, supply, and demand reach an equilibrium.

Utility explains why similar goods can have entirely different supply, demand, and price curves. It also explains why people will generally pay a lot of money for scarce goods. If they offer enough utility, the expense is worth it.

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