What is utility theory?

The utility theory in economics is stated based on an individual’s preferences. It explains the behavior of individuals. Depending on the assumption, people can be ranked in order of their preferences. In other words, utility means the property in an object that brings benefit, advantage, pleasure, well-being, welfare, good, or happiness.

Utility theory is a positive theory. It explains the individual’s behavior and choices. On the other hand, the normative theory is a prescriptive theory that tells people what they should do. In theory, the restrictions on the preferences can be represented using a utility function.

Types of utility

Ordinal utility

In microeconomics, the ordinal utility function represents the preferences of an individual on an ordinal scale. In this theory, consumer decision-making under certain conditions can be expressed in terms of ordinal utility. The theory states that it is sensible to ask only what option is better and not how good an option is.

Marginal utility

Marginal utility defines the satisfaction or benefit obtained by consuming a product. The marginal utility of a product or service determines the amount of pleasure or satisfaction gained from its consumption. The marginal utility can have a positive, negative, or zero value.

For instance, if someone purchases a product and does not like it, the marginal utility will be zero. If the consumption of the product is unnecessary, the marginal utility will be negative. Contrarily, if satisfaction is gained by consuming a product, the marginal utility will be positive.

Cardinal utility

According to economist Bernoulli, utility is a quantifiable property of goods that an individual consumes. To measure this satisfaction, a unit called util is used. A cardinal utility function is the utility index that maintains decisions ordering individually for positive affine transformations.

Total utility

Total utility (TU) is the sum of satisfaction that an individual gets by consuming all the units of a product or service. If a person consumes chocolate with two pieces, where the value of the first piece is four utils and the second is six utils, the total utility value will be ten utils.

Assumptions in utility theory

Utility theory follows several assumptions, as mentioned below.

Completeness

People can rank order all the bundles. Rank ordering means that regardless of the combinations of the bundles placed in front of individuals, the people can rank the bundles based on their choice preferences. They may compare the bundles with each other and rank them based on the satisfaction that each bundle will provide them. This property of allowing individuals to compare one bundle with another based on their preferences is called completeness.

The more is better

Suppose a person decides to consume a bundle X of products to bundle Y. If the person is offered another bundle XA that contains more of everything in bundle X, according to the more is better theory, the individual will pick XA bundle. The more is better theory is referred to as monotonicity assumption. The property allows costless disposal of the extra quantities of the bundle that an individual consumes.

The mix is better

If a person is fair to consuming clothes for a week and food for another week, either choice is not preferred over another. According to the mix is better property. It is assumed that the preference of mixing two consumptions would be preferred over stand-alone choices. This assumption is also known as the convexity assumption.

Rationality

Rationality is a significant assumption in the utility theory. According to the assumption, a person’s preference avoids circularity. That means if a bundle X is preferred to bundle Y, and bundle Y is preferred to bundle Z, then X is preferred to Z, but an individual will never prefer bundle Z to X. This assumption is controversial. It assumes that the intrinsic preferences are fixed, despite the context and time.

When these four utility assumptions are satisfied, a well-behaved utility function can determine the individual’s preferences. A well-behaved utility depends on the amount of wealth a person owns.

Expected utility

Expected utility theory summarizes the utility that an entity or aggregate economy may reach under certain circumstances. It is measured by considering the weighted average of all probable outcomes under certain situations. The weights are allotted based on the probability of an event occurring. The expected utility theory was declared by economist Daniel Bernoulli, who applied it to solve the St. Petersburg Paradox.

The expected utility of an object is calculated from the expected utility hypothesis. The expected utility theory states that the weighted average value of all possible utility levels will be best represented under uncertainty.

Expected utility theory is utilized as a tool to analyze situations where people should make decisions without considering the subjective probabilities (outcomes of the decision). Such people choose the action that will give the highest expected utility. The decision-making will also depend on the agent’s risk-averse and other agents’ utility. The expected utility theory claims that the utility of money is not equal to the total value of money.

Indifference curve

In economics, an indifference curve links points on a graph representing different quantities of two goods that leave a customer indifferent. The combinations of two goods shown by the graph will determine the consumer equal levels of utility, and the consumer will not have a preference for one combination or bundle of goods over another. Each point on the indifference curve can be considered rendering at the same level of satisfaction (utility).

An indifference curve is the locus of several points representing combinations of two goods offering equal utility to consumers.

Context and Applications

Utility theory is an important concept to understand consumer behavior. The concepts of utility are studied in:

• Bachelors in Economics.
• Bachelors in Finance.
• Masters in Artificial Intelligence.
• Masters in Economics.
• Masters in Finance.

Practice Problems

1. In which subject is consumer behavior studied?

1. Microeconomics
2. Tversky probability
3. Raiffa value theory
4. Macroeconomics

Answer: Option a

Explanation: Microeconomics includes studies related to how people make decisions to choose between various goods and other factors related to purchases. It involves consumer behavior studies.

2. What is the ability to satisfy human desires of a good called?

1. Satisfaction value
2. Preference relation
3. Utility
4. Maximize trade-offs

Answer: Option c

Explanation: Utility theory helps understand consumer behavior, decision-making, and the satisfaction an individual gets after consuming a product or service.

3. Which of the following is not valid for utility?

1. The utility is always measurable
2. The utility is a satisfying power of a commodity
3. The utility assists consumers in making preferences.
4. The theory is subjective.

Answer: Option a

Explanation: The utility theory is a subjective concept that is different for every person. However, the utility cannot be measured. Consequently, the first option is incorrect.

4. Which of the following shows the combination of two products that give the same level of satisfaction to the consumer?

1. Maximize preference relation
2. Indifference curve
3. Loomes subjective probabilities
4. Kyburg maximize theory

Answer: Option b

Explanation: The indifference curve consists of points representing the combination of two goods giving the same level of satisfaction to the consumer and leaving the consumer indifferent.

5. Which utility approach suggests that utility is a measurable and quantifiable entity?

1. Ordinal value
2. Cardinal utility
3. Marginal utility
4. Expected utility theory

Answer: Option b

Explanation: With the cardinal utility, utility is measured numerically, and it is used in utils.

Common Mistakes

Expected utility theory and marginal utility are related concepts. However, it is worth noting that expected utility theory may not be applicable on modest stakes. Further, expected utility theory fails when incremental marginal utility values are trivial.

Related Concepts

• Law of diminishing marginal utility
• Supply and demand
• The risk management function
• Elasticity