The Definition of Utility in Economics

In economics, utility refers to the satisfaction levels consumers receive from buying and using a product or service. According to utility theory, people make purchase decisions based on the degree of satisfaction they get from an item or service. That is why goods with higher utility are prioritized higher in a person’s budget. Understanding what utility is can also provide insight into what drives demand and prices.

In the mid-17th century, the maximization of expected value was introduced. This theory states that an item’s expected value is based on the sum of the product of probability, as well as the value of its consequences. However, conflicting prescriptions for certain situations arose. Mathematician Daniel Bernoulli then proposed the concept of utility. He argued that an item’s value is not determined by its price but by its utility, and that utility is what affects consumers’ purchasing decisions. Utility in economics can also impact market demand, which can affect product or service prices.

One of behavioral economics concepts is utility and refers to the perceived value that consumers receive when they buy a product or service. Generally, there are four types of utility, including form, time, space and service. While each of them can significantly affect decision-making, the level of impact of these utilities on purchasing decisions varies by individual.

Utility function is the measurement of consumer preferences. There are two ways to rank preferences. The first is by assigning numerical values to items and determining which has a higher utility based on the numbers. For instance, product X has higher utility than product Y. That means consumers prefer product X over product Y. Utility function assigns a higher value to the more preferred item.

The second method is to rank products or services based on preference. This may include assessing what is being offered to the consumer and determining if it has a higher utility because consumers prefer what it offers them versus what it costs.

Under utility theory, one can assume that consumers behave and act as if they are assigning implicit values to products.

Imagine you are shopping around for car insurance. After careful consideration, you have narrowed your choices to two insurance providers. Both companies offer nearly identical policies. However, the second one provides free roadside assistance service. Because of this, it has higher premium rates than the first one. You can see there is an exchange or trade-off here: would you want to have lower premium rates in exchange for roadside assistance? This is an example of numerical values impacting utility function.

Another example is when you go out for a meal at a restaurant. Of all the menu items, two dishes catch your attention. One is a pasta dish and the other is pizza. Realizing that you will enjoy the pizza more, you decide to order it. This is an example of how preference can impact utility function.

Utility function is a way to determine the desirability of products or services. However, there is some debate on whether it is possible to measure utility or not. One can argue that you cannot assign true numerical values to the level of satisfaction of consumers based on their preference. That said, assigning numbers to utility can help track spending patterns and market movements.

To better understand utility in economics, it is important to know the two approaches in economics — ordinal and cardinal.

Utility highlights the relationship between consumer behavior and demand. It showcases how consumers allocate money to available products or services to achieve utility maximization. For example, as a rational consumer, purchases are made by considering how much satisfaction will be obtained from the item or service.

In order to understand satisfaction levels, the cardinal and ordinal utility theories are used. MoneyGeek breaks down the key differences in the table below.

Cardinal utility is the quantitative measurement of consumer satisfaction. It uses a unit “util” that represents psychological satisfaction through numbers. This allows for mathematical calculations. Unlike ordinal utility, cardinal utility focuses on the consumption of one product at a time.

Assumptions of cardinal utility includes:

• The consumer rationally seeks to maximize satisfaction from their limited disposable income.
• The utility of each product or service is measurable.
• If you use the monetary unit to measure utility, it has to be constant.
• Utility diminishes as a person consumes a commodity in successive units.

Assigning utils may vary per person. For example, you consider whether you should buy a steak or a fish fillet. Based on your preference, you give the steak 10 utils. Meanwhile, you assign seven utils to the fish. Your cardinal utility is denoting that steak is the option that will give you greater satisfaction.

It is important to note that it is possible for utils to decrease as you consume more. If your steak yields 10 utils, it is possible its value will lessen as you eat more, begin to feel full and aren’t enjoying the steak as much as you did at the start.

Ordinal utility, on the other hand, is qualitative. It is based on the following assumptions:

• Consumers are rational. They aim to maximize total utility based on the limited income at their disposal and the prices of the products or services.
• The utility of each product is not measurable by numbers. Instead, they can be ranked based on the order of preference.
• Consumers are consistent with their choices.
• Consumers are willing to exchange between two goods to maintain the level of satisfaction.
• Total utility is based on the number of commodities they consume. That means it adds different utilities.
• Consumers would always opt for a larger bundle of products or services over a smaller bundle with the same items.

Generally, ordinal utility focuses on a person's preference. For example, imagine you are given three options at a café. These include coffee, milk and tea. Based on what you like, you rank the three items with coffee as the one you prefer the most and tea as your last choice. That means your ranking order is coffee > milk > tea. This order reflects your preference. However, it does not show how much you like coffee more than milk and tea.

There are two ways to view utility. First, there is total utility. It refers to the sum of a person’s satisfaction from consuming all units of a certain commodity. The second one is marginal utility, wherein additional utility is gained as a person consumes additional units of a product or service.

Total utility is the aggregate amount of all utilities a person gained from consuming a certain amount of a product or service within their income level or budget constraint.

The total utility changes as consumption of the same product increases. The first unit consumed has the highest utility. The second unit has a lower utility than the first, and so on. That means the growth in the total utility becomes less as an additional unit is consumed.

Total utility is the summation of all utilities. It is represented in utils.

In most cases, economists evaluate utils across a spectrum. This way, they get a comparative analysis of util amounts or how much satisfaction is gained from every additional unit. It is important to assign a base value for utils when determining total utility.

The formula is simple. You determine the total based on the numerical value assigned for each.

To better understand total utility, here is an example:

Mark is hungry, so he orders a pepperoni pizza. Under the concept of total utility, it is assumed that Mark’s satisfaction level varies for each slice he eats.

The first slice will give him the highest level of satisfaction, given that he’s hungry and pepperoni is his favorite type of pizza. The second slice has lower utility than the first. By the third slice, he’s experiencing an even lower utility and satisfaction than the second. This situation happens because Mark’s appetite and desire for the pizza decreases as he consumes each slice.

The table and graph below represent the total utility Mark experiences from eating the pizza. The utility utils increase, while the Law of Diminishing Marginal Utility shows that with each additional piece of pizza, Mark’s appetite and desire for more food decreases.

Using the data from the table above, we can plot the total utility of Mark's pizza experience on a graph. Take a look at the graph below and compare it with the table above.

Marginal utility represents the level of fulfillment a person gets as they consume more units of the same product or service. It reflects the changes in the perceived satisfaction of a consumer for every additional unit. Understanding marginal utility helps assess the change in a person's perception of a commodity.

The best way to understand marginal and total utility is through the Law of Diminishing Marginal Utility. It states that additional satisfaction decreases as you consume more of a single product or service.

The formula to calculate marginal utility can be defined as the change in total utility divided by the change in units of the commodity.

It can be represented as:

Using the example of Mark and his pizza, we can make the observation that despite the increase in total utility, the increase in utils lessens as Mark eats more slices of pizza.

Marginal utility can be visualized as:

Notice how marginal utility lessens as Mark consumes more pizza slices. That is because a consumer, once their needs or wants are met, gets the greatest level of satisfaction from the first unit of the product.

To calculate marginal utility:

1st slice: (10 - 0) / (1 - 0) = 10
2nd slice: (19 - 10) / (2 - 1) = 9
3rd slice: (27 -19) / (3 - 2) = 8
4th slice: (34 – 17) / (4 - 3) = 7

The concept of utility maximization can be described as a strategy used to achieve the highest level of fulfillment from their decision. To determine the combination of products or services that will help maximize utility, compare the marginal utility of the options. Then, find an alternative that offers the highest total utility within the budget constraints. The rule for utility maximization calculates how many units of an item a consumer will purchase. It relies on the idea that people tend to buy what they want.

Utility maximization can be best understood through the following formula:

The formula shows that every dollar spent on a product or service should bring the same amount of marginal utility. This way, the consumer has spent their money well and can remain within the budget they created and maintain.

For example, Bart wants to buy meat at the grocery store. He has a $20 budget and is choosing between a pound of beef and a pound of pork. He gives beef 10 utils and pork eight utils. A pound of beef costs $10, while a pound of pork costs $5.In this situation, for Bart to maximize his budget and his total utility in his purchases, we will have to take a closer look at each meat.

Take a look at the two tables below of each of the meat.

From the two tables above, Bart’s budget allows him to purchase both beef and pork or purchase only one type of meat. For example, Bart can purchase 2 pounds of beef for $20, which gives him 17 utils, or 4 pounds of pork at $20, giving him 20 utils.

If Bart wants to maximize his utility, he will buy both types of meat until he reaches his budget. His best option is 1 pound of beef for $10 at 10 utils and 2 pounds of pork for $10 at 14 utils for a total of $20 at 24 utils.

Utility is only one aspect affecting the economy. MoneyGeek has researched other financial and economic concepts and created a variety of guides to help you make better financial choices.

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