What Is Utility?
In economics, utility is a concept used to evaluate the worth or value of a good or service. More specifically, utility represents the total satisfaction or benefit derived from consuming a good or service. Economic models grounded in rational choice theory typically assume that consumers seek to maximize their utility.
The economic utility of a good or service is critical because it directly impacts demand and, consequently, the price of that good or service. Though a consumer’s utility is usually difficult to measure directly, economists can estimate it through various models.
Key Takeaways
- Utility refers to the usefulness or enjoyment obtained from a service or good.
- Though abstract, the concept of utility helps explain consumer decision-making processes.
- “Ordinal” utility denotes that one good may be more useful or desirable than another.
- “Cardinal” utility involves quantifying economic value using a theoretical unit called “utils.”
- Marginal utility is the additional utility gained from consuming an extra unit of a service or good.
Understanding Utility
The definition of utility in economics is derived from the idea of usefulness. An economic good provides utility to the extent that it satisfies a consumer’s want or need. Different economic schools of thought have developed varied methods for modeling and measuring the utility of a good or service.
Ordinal Utility
Early economists from the Spanish Scholastic tradition posited that the economic value of goods arose from their usefulness. This view was qualitative rather than quantitative. The Austrian School later developed this idea into an ordinal theory of utility, suggesting that individuals could rank the usefulness of various discrete units of economic goods. Austrian economist Carl Menger used this framework to explain the law of diminishing marginal utility and fundamental economic principles like the laws of supply and demand.
Cardinal Utility
The concept of cardinal utility involves thinking of utility as a quantifiable entity. Economists employ a hypothetical unit called a “util” to represent the psychological satisfaction a specific good or service generates. While this allows economic relationships to be analyzed mathematically, “utils” are not observable or measurable in real life.
For example, if an individual regards a piece of pizza as providing 10 utils and a bowl of pasta 12 utils, the bowl of pasta offers more satisfaction. For producers, knowing that pasta provides more utils can justify higher pricing compared to pizza.
However, as more units of a product are consumed, the utils it provides may decrease. This idea can help consumers allocate their money more effectively and aid companies in structuring tiered pricing.
Total Utility
If utility is measurable, the total utility (TU) is the sum of satisfaction from consuming all units of a specific product or service. For example, three slices of pizza with utils of 10, 8, and 2 respectively, result in a total utility of 20 utils.
Marginal Utility
Marginal utility (MU) refers to the additional utility gained from consuming one more unit of a good or service. Using the pizza example: the first slice may yield 10 utils, the second 8 utils, and the third 2 utils, making the MU for each additional slice 8 and 2 utils, respectively.
In ordinal terms, a person might differently prioritize additional slices by various uses, such as sharing, saving, or repurposing.
How Do You Measure Economic Utility?
While it’s challenging to measure utility directly, economists can estimate it through indirect observation. For instance, if a consumer is willing to pay $1 for a bottle of water but not $1.50, its utility lies somewhere between $1 and $1.50. However, this estimate becomes complex due to numerous variables affecting consumer choices.
The 4 Types of Economic Utility
In behavioral economics, the four types of economic utility are form utility, time utility, place utility, and possession utility. These refer to the psychological significance of different forms of utility, such as the design of a product (form utility) or the timeliness of a service (time utility).
Investing in Utilities
Utilities are companies in sectors like electricity, water, oil, and gas. They are major players in industrial economies with substantial market capitalization. Investors can opt for individual companies or funds focused on the utilities sector.
The Bottom Line
Utility is a crucial concept for understanding the usefulness of goods and services to consumers. While utility has measurement limitations due to market variables, its different types offer valuable insights. This knowledge helps companies with pricing strategies and enables consumers to maximize the satisfaction of their purchases.
Related Terms: consumer choice, law of supply and demand, behavioral economics, marginal revolution.
References
- University of Minnesota Library. “Principles of Economics: 7.1 The Concept of Utility”.
- American Economic Association. “How Economists Came to Accept Expected Utility Theory: The Case of Samuelson and Savage”, Page 220.
- The Online Library of Liberty. “Early Economic Thought in Spain, 1177-1740”, Download PDF, Pages 87-90.
- Mises Institute. “Why Austrians Stress Ordinal Utility”.
- The Library of Economics and Liberty. “Carl Menger”.
- U.S. Energy Information Administration. “Alternative Measures of Welfare in Macroeconomic Models”, Pages 1-2.
