Let’s say you just started to study something new. You feel excited after you have completed your one-hour lesson and learned something. The following hour, you study more and you learn further. Another hour passes by, and you add to your knowledge. However, after studying for six to eight hours, you feel exhausted because during the first hours you put your brain under a lot of pressure to learn and memorise.
This is what utility theory is all about: the degree of satisfaction or usefulness derived from consuming a product or service.
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.
If John is drinking his first glass of water and gets 10 units of satisfaction, the marginal utility he derives from the first glass is 10 units. He then has a second glass of water and gets 8 units of satisfaction. The marginal utility he derives from the second glass is 8 units. With the third glass, he gets only 7 units of satisfaction. Thus, the marginal utility he derives from the third glass is 7 units.
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.
Continuing with our previous example, where John derived 10, 8, and 7 units of utility from the glasses of water, the total utility that John would derive is 10 + 8 + 7 = 25 units.
The equation for total utility (TU) is:
Where MU-N is the marginal utility from consuming the N-th unit of a good.
| Number of glasses of water | Marginal utility | Total utility |
| 1 | 10 | 10 |
| 2 | 8 | 18 |
| 3 | 7 | 25 |
| 4 | 4 | 29 |
| 5 | 0 | 29 |
| 6 | -2 | 27 |
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.
Suppose Alan is very hungry and decides to eat a hamburger. The first burger satisfies his hunger. However, he is still hungry, so he buys another burger. This further satisfies his hunger. However, not as much as the first burger. He goes on to have a third burger to fill the little hunger he still has and gets fully satisfied. Any further burger will not satisfy Alan's hunger and might be a bit too much for him to eat. It may make him feel too full and may also result in him feeling sick. Thus, the fourth burger may not give any satisfaction to Alan and instead give him a negative utility.
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.
Imagine you are paying a tutor to help you with maths five days per week. However, the tutor isn't available at least two or three times per week as initially agreed. Would you be happy with that? Would you be satisfied with the tutor and willing to pay the same price? The answer is generally no. If someone is paying for five days a week tuition fee, they will expect to receive the tutoring hours they paid for. This is utility maximisation.
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.
Richard wishes to have a Ferrari car. However, his income just covers his basic needs of food, clothing, shelter, and a comparatively cheaper car. He has no budget for a Ferrari. In his case, limited income stops him from having the car that will satisfy him the most.
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.
Many people like McVities digestive biscuits. However, some decide not to buy them because they have a high price. They may opt for cheaper available alternatives like a supermarket's own brand of digestive biscuits.
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.
If Richard, the man who wants a Ferrari, has limited savings and is not willing to borrow money, his budget constraint will restrain him from buying the luxury car. His budget constraints don't allow him to make the choice that would maximise his utility.
Limited time
Another constraint consumers may face while making choices is the availability of time.
Suppose an individual is willing to get the goods currently on sale. However, they could not go to the store to buy the goods on time for the sale. They will not enjoy the maximum utility they would have gained if they purchased the good when the price was affordable for them.
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.
Utility Theory - Key takeaways
Utility is the level of satisfaction a person derives from consuming a good or service.
Utility theory explains individuals’ choices and measures their level of satisfaction from consuming a good or service. The level of satisfaction is measured in units called ‘utils.’
Marginal utility is the satisfaction that a person receives from consuming an additional unit of the same good or service.
Total utility is the aggregate satisfaction a person receives from consuming all the units of the same good or service.
As the number of units increases, marginal utility decreases, and total utility increases. When the total utility reaches its maximum level, the marginal utility is zero. After that point, marginal utility starts to get negative and total utility starts decreasing.
The Law of diminishing marginal utility states that an individual’s level of satisfaction diminishes as the use of the same product increases. Eventually, the consumer either looks for an alternative or stops consuming the product.
Utility maximisation is the highest level of satisfaction a consumer is able to derive from the decision they made in return for the cost they paid.
Individual choices when trying to maximise utility may be limited by income, prices, time, and budget constraints.
FAQs
What is utility theory and examples? ›
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.
What is the meaning of utility of theory? ›Utility theory is a positive theory. that seeks to explain the individuals' observed behavior and choices. The distinction between normative and positive aspects of a theory is very important in the discipline of economics.
What is an example of expected utility theory in real life? ›Example of Expected Utility
For example, purchasing a lottery ticket represents two possible outcomes for the buyer. They could end up losing the amount they invested in buying the ticket, or they could end up making a smart profit by winning either a portion of the entire lottery.
Assumptions of Utility Theory
This means that individuals' preferences remain constant over time, and they can rank different options logically. For example, if an individual prefers option A over option B and option B over option C, they must prefer option A over option C.
For example, necessities like food and water provide a consumer with a very high value or utility. That is, until the consumer obtains enough food and water to satisfy their physical needs. Once they satisfy this need, the marginal utility of these goods would drop.
What are the 4 types of utility examples? ›There are four basic principles that fall under this umbrella, including form utility, time utility, place utility, and possession utility.
How do you use utility theory? ›- define the problem.
- identify the decision criteria.
- weight the criteria.
- generate alternatives.
- rate each alternative on each criterion.
- compute the optimal decision.
Generally speaking, utility refers to the degree of pleasure or satisfaction (or removed discomfort) that an individual receives from an economic act. An example would be a consumer purchasing a hamburger to alleviate hunger pangs and to enjoy a tasty meal, providing her with some utility.
What are the two types of utility theory? ›There are two types of utility, namely, total utility and marginal utility.
Which of the following is an example of utility *? ›Utility Software performs certain tasks like virus detection, installation, and un-installation, data backup, deletion of unwanted files, etc. Some examples are antivirus software, file management tools, compression tools, disk management tools, etc.
What is expected utility theory simple? ›
Expected utility theory provides a way of ranking the acts according to how choiceworthy they are: the higher the expected utility, the better it is to choose the act. (It is therefore best to choose the act with the highest expected utility—or one of them, in the event that several acts are tied.)
What is an example of law of utility? ›The utility is the degree of satisfaction or pleasure a consumer gets from an economic act. For example, a consumer can purchase a sandwich so they are no longer hungry, thus the sandwich provides some utility.
What is an example of subjective utility theory? ›Examples: Random experiments like a horse race, the next elections, the price of a stock, a car accident, the weather etc. Here the probabilities are not “objectively known” to the decision maker. The decision maker has to form subjective beliefs.
What are examples of utility maximization theory? ›Utility maximization is a strategic scheme whereby individuals and companies seek to achieve the highest level of satisfaction from their economic decisions. For example, when a company's resources are limited, management will implement a plan of purchasing goods or services that provides the maximum benefit.
What is utility theory in human rights? ›Utilitarian rights are structured so that the hierarchy is (1) general utility of goods, (2) duties of individuals or government to maximize these utilities, and (3) the possible rights of individuals are consequential to the maximizing of these goods.
What are 5 examples of utilities? ›The Utilities sector comprises establishments engaged in the provision of the following utility services: electric power, natural gas, steam supply, water supply, and sewage removal.
What is an example sentence for utility? ›Gas and electricity are essential utilities and they should be taken back into public ownership. The sport utility vehicle is a staple of modern motoring, and few car companies do without at least one in their range. Only a truly addictive service, a utility, could command such power.
Which is the best example of place utility? ›One example can be availability of water and other drinks near marathon venues or other sporting events. this is one way to look at place utility. Other utility is for example, swiss chocolates.
What is the full meaning of utility? ›1 of 2 noun. util·i·ty yü-ˈtil-ət-ē plural utilities. : the quality or state of being useful : usefulness. : something useful or designed for use.
What are the most common types of utility? ›Utilities are the basic services your home, apartment, or business needs to keep it comfortable and functioning properly. Common utilities include water, sewer, electric, gas, trash, and recycling. Technology subscriptions like cable TV, internet, security, and phone service can also be considered utilities.
What are the 3 different types of utility? ›
Place utility: this utility is derived when you can transport goods from one place to another. Time utility: it is derived by keeping or storing goods over a period of time so that they can be used later. Service utility: it is derived by rendering professional services to consumers.
What is the modern utility theory? ›The modern utility analysis is the outcome of the failure of the indifference curve technique to explain consumer behaviour among risky or uncertain choices. The traditional utility analysis is also concerned with consumer behaviour among riskless choices.
How is utility theory measured? ›Utility measures the amount of satisfaction that an individual receives from a product or service. Utility comes in two types: cardinal and marginal. Cardinal utility assigns a number to the utility, such as a basket of apples gives a utility of 10 and a bushel of corn is 20.
What is an example of utility and value? ›A cigarette has a utility to the smoker but it is injurious to his health. Resources are anything that has utility and adds value to your life. The value of each such resource depends on its utility and other factors. For example, silver and gold have economic value; i.e. they can be exchanged for money.
What is the meaning of utility in economics? ›Utility, in economics, refers to the usefulness or enjoyment a consumer can get from a service or good. Although the concept of utility is abstract, it is a useful way to explain how and why consumers make their decisions. "Ordinal" utility refers to the concept of one good being more useful or desirable than another.
What are the uses of utility in economics? ›As a topic of economics, utility is used to model worth or value. Its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or happiness as part of the theory of utilitarianism by moral philosophers such as Jeremy Bentham and John Stuart Mill.
What are the advantages of utility theory? ›In addition to providing an explanation of consumer disposition of income, utility theory is useful in establishing individual consumer demand curves for goods and services. A consumer's demand curve for a good or service shows the different quantities that consumers purchase at various alternative prices.
Which is not an example of utility? ›Lotus 123 is not an example of utility software.
The main use of utility software is to maintain, manage and control the computer resources. The operating system of computer has some necessary tools for this but separate utility programs can improve functionally.
System utility programs are used to list or change information that is related to data sets and volumes, such as data set names, catalog entries, and volume labels. Most functions that system utility programs can perform are performed more efficiently with other programs, such as IDCAMS, ISMF, or DFSMSrmm™.
Who created utility theory? ›Daniel Bernoulli is famous for founding the Utility Theory in the 18th century.
What is the formula for utility theory? ›
To find total utility economists use the following basic total utility formula: TU = U1 + MU2 + MU3 … The total utility is equal to the sum of utils gained from each unit of consumption. In the equation, each unit of consumption is expected to have slightly less utility as more units are consumed.
Which best defines utility? ›Answer and Explanation: The best explanation of utility is the satisfaction of consuming goods or services. The satisfaction that is received from consuming goods and services is referred to as utility.
What are the different types of utility? ›There are mainly four kinds of utility: form utility, place utility, time utility, and possession utility.
What are 5 examples of utility business? ›The Utilities sector comprises establishments engaged in the provision of the following utility services: electric power, natural gas, steam supply, water supply, and sewage removal.
What are 5 examples of economic utility? ›the ability of a good or service to satisfy a customer's needs or wants; the five kinds of economic utility are form utility, time utility, place utility, information utility and possession utility.
Which of the following is an example of utility? ›Utility Software performs certain tasks like virus detection, installation, and un-installation, data backup, deletion of unwanted files, etc. Some examples are antivirus software, file management tools, compression tools, disk management tools, etc.
Which is an example of utilities? ›Utility services include telecommunications, electrical utilities, natural gas, certain transportation services, and also water and wastewater treatment services provided by private companies.
What is a simple example of place utility? ›Place utility can be used to draw customers to a product or service as well because it associates a specific place to the product or service. For example, someone from America might find French wine more appealing because of its association with the city as being foreign and, thus, more attractive.
What are examples of utility functions in economics? ›Utility function measures the preferences consumers apply to their consumption of goods and services. For instance, if a customer prefers apples to oranges no matter the amount consumed, the utility function could be expressed as U(apples) > U(oranges).
What is an example of total utility in economics? ›For example, a cookie provides a level of utility as determined by its singular consumption, while a bag of cookies may provide total utility over the course of time it takes to completely consume all the cookies in the bag.
What is an example of public utility in economics? ›
A public utility is an entity that provides goods or services to the general public. Public utilities may include common carriers as well as corporations that provide electric, gas, water, heat, and television cable systems.
What are the different types of utility theory? ›In behavioral economics, the four types of economic utility are form utility, time utility, place utility, and possession utility.
What is more example of marginal utility? ›Marginal utility is the enjoyment a consumer gets from each additional unit of consumption. It calculates the utility beyond the first product consumed. If you buy a bottle of water and then a second one, the utility gained from the second bottle of water is the marginal utility.
What is utility in economics? ›Utility refers to the comprehensive benefits obtained from consuming an item or service. This sums up the utility definition. Consumers would typically aim to maximise their utility based on rational choice based on economic models.