Table of Contents
- What is Utility in Economics?
- Characteristics of utility
- Types of utility
- Utility theories and approaches (schools of thought)
- The cardinal theory
- The ordinal theory
- Concepts of the total, average, and marginal utility
- Utility maximization and the rational choice theory
- The law of diminishing marginal utility
What is Utility in Economics?
Utility in Economics is the pleasure/satisfaction a consumer derives from consuming a commodity or service. It is a vital concept of consumer behavior, so we cannot separate the concept of utility from the theory of consumer behavior.
The concept of utility
The concept refers to the amount of satisfaction a consumer derives from consuming a commodity at a particular time. For instance, the satisfaction of a tin of milk is the amount of satisfaction derived from consuming it. Any commodity that has the ability to satisfy human wants possesses utility. We can say that it is the power of a commodity to satisfy wants. It can be either actual or expected, which a consumer derives from consuming a commodity. It varies from person to person, time to time, and place to place.
Prof. Hobson stated that “utility is the ability of a good to satisfy wants”. We conclude that a commodity possesses utility when it has the capability to satisfy human wants. We determine the utility of goods and services by how much satisfaction a consumer derives from them. It is not the same as the intrinsic quality in the commodity or service itself.
Characteristics of utility
It is important to note the following characteristics of utility:
It is not the same as usefulness
Some commodities may be useful but they may not possess pleasure at a particular time for a consumer. For example, water is useful to man but it possesses no utility to a drowning man. It does not satisfy his wants at that moment.
No ethical significance
It does not have ethical significance. Something may be bad but still possess some satisfaction for an individual such as cigarettes. While something good may not possess any satisfaction for an individual at a particular time.
A strong relationship with time
There is no fixed amount of utility for a particular commodity. The amount of satisfaction a consumer derives from a particular commodity may not be the same for that consumer at different times. For example, the satisfaction one derives from consuming ice cream will be higher during hot weather than during cold weather.
It differs among individuals
The amount of satisfaction a consumer derives from consuming a commodity at a particular time differs from one individual to the other. For example, a plate of food possesses a high amount of satisfaction for a hungry man. But it has little or no satisfaction for someone who has just eaten. Also, a consumer may derive satisfaction (either high or low) from the same commodity at different times.
It is Psychological
Utility depends on the mental attitude of a consumer regarding the ability of a commodity to satisfy his particular want. In psychological terms, every consumer has his own likes and dislikes as well as determines his own satisfaction level.
We cannot measure utility objectively
We cannot express the feelings and satisfaction of a consumer in numerical terms. Measuring it cardinally or directly in a precise manner does not work.
It is different from pleasure
The consumption of a commodity may possess satisfaction but possesses to the consumer. A drip, an injection, or drugs give no pleasure to the patient but are necessary for his recovery.
It depends on the degree of want
The satisfaction one gets from a commodity is the product of the degree of want. An unsatisfied want is usually intense greatly, leading to a high level of satisfaction from that commodity to the consumer. When a consumer satisfies his want in the process of consuming a particular commodity, he experiences less satisfaction than when he started the consumption. This experience is common and it has to do with the law of diminishing marginal utility. The more we consume a commodity, the less we want to consume more.
Types of utility
The following are the types of utility;
The involves a change in the form of a particular commodity. Changing the form of a commodity through manufacturing processes tends to increase its satisfaction. That is, a change in the structure of a commodity increases the amount of satisfaction that a consumer can derive from it. In other words, this form of utility comes about through the manufacturing of goods. For example, a bakery converts flour to bread. Raw flour does not satisfy a consumer who wants to eat bread.
This has to do with changing the geographical situation of a commodity. When a company transports a commodity from where it has little utility to a place where it has a higher utility. That is, utility comes about as a result of transporting goods from one place to another. Marketing goods from the company to the marketplace creates satisfaction. In the same way, grain merchants create utility by, shifting food grains from the farm to the marketplace.
In essence, transport services are basic tools involved in creating a place utility. Talking about retail trade and distribution services, they are key factors in stimulating a place utility. Also, mining and fisheries entail creating this form of satisfaction. Place utility is usually more in areas where the commodities are scarce than in areas where the commodities are abundant.
This factor involves the storage of goods until the need for them arises. You can increase the satisfaction of a commodity by preserving it for future use. In other words, hoarding, storing, and preserving certain commodities over a period of time most times lead to the creation of time utility. A typical example is farmers strong or hoarding food grains at the time of harvest and releasing them for sale during a period of scarcity. In this case, traders gain more advantage from this because they fetch a higher price. trading basically involves the creation of satisfaction which relates to time
Rendering (personal) services to customers by professionals such as lawyers, doctors, etc., creates service utility. In this case, these professionals satisfy human wants thereby creating satisfaction, from the abundance of their specialized knowledge and skills.
Changing the possession of a commodity creates possession utility. For example, a farming implement may not be useful to a banker. But if a commercial farmer owns it, then he gains satisfaction from it.
This factor increases with the proportional increase in the knowledge about the use of a commodity. Propagandas and advertisements are key elements relating to this subject matter.
Natural factors such as rain, water, air, sunshine, and trees possess natural utility. They are free goods that are capable of satisfying our wants. For example, sunlight creates satisfaction for someone who wants to dry his clothes.
Utility theories and approaches (schools of thought)
There are two basic approaches to measuring utility, these are;
- The cardinal (quantitative or neoclassical) approach
- The ordinal approach
The cardinal theory
The cardinal approach assumes that utility is measurable. Some economists suggest that we can measure utility in monetary terms in a monetary unit. Measuring utility monetary unit involves the amount of money the consumer is willing to sacrifice for another unit of commodity. Others suggested that the measurement of utility should be in subjective form.
Classical economists proposed the cardinal utility theory. These economists include Gossen (Germany), William Stanley Jevons (England), Leon Walras (France), and Karl Menger (Australia)
A neoclassical economist later brought about a significant distinction in the theory. The cardinal utility theory is therefore known as the neoclassical economic theory.
The neoclassical economists believe that the term is quantitative (measurable) just like other mathematical variables like temperature, height, velocity, speed, etc. They developed a unit to be used in measuring utility known as UTILS. For example, based on the cardinal utility theory, a consumer gains 30 utils from consuming chocolate and 20 utils from consuming cupcakes. The theory assumes that one util is equal to one unit of money and that the utility of money remains constant.
Assumptions of the cardinal theory
The consumer is rational, he aims at maximizing his satisfaction. It is subject to the constraints his given income imposes. According to the cardinal theory, a consumer arrives at his equilibrium when the last unit of money he spends on each commodity yields the same satisfaction. This means that a consumer spends his money on commodity X as long as;
MUx > Px (MUm) where,
Px = Price of commodity X
MUx = Marginal utility of commodity X
MUm = Marginal utility of money.
The basic assumption of this theory is that the satisfaction of each commodity is measurable in a monetary unit. According to Marshall, they use money to measure the utility of different commodities. It means that the amount of money a consumer is willing to pay for a commodity is equal to the measure of its usefulness or satisfaction.
A constant marginal utility of money
The important characteristic of a standard unit of measurement is that it is constant. It assumes that money has to measure the same amount of satisfaction under every circumstance. If the marginal utility of money changes as income increases or decreases, the measuring rod becomes like an elastic ruler which is not appropriate for measurement. In a simplified way, the satisfaction derived from each unit of money does not change.
They are additive
The assumption states that the satisfaction a consumer derives from different commodities can be added to derive total satisfaction. Thus;
Un = U1(X1) + U2(X2) + …….+ Un(Xn).
Diminishing marginal utility
A commodity’s marginal utility diminishes as an individual consumes additional units of a commodity. Thus;
MUX = f(Qx) where,
MUX = Marginal utility of commodity X
f = Function
Qx = Quantity of the commodity consumed.
The ordinal theory
This approach explains that satisfaction cannot be measured in numbers, but we can arrange them in the order of preferences. That is, the utility function generates a ranking market basket in the order of most preferred to the least preferred.
John Hicks and R.J. Allen (English economists) argued that they should develop the theory of consumer behavior based on the ordinal utility approach.
According to this theory, utility is psychological such as happiness and satisfaction. It varies from person to person and is highly subjective in nature. Because of this, we cannot measure it in quantifiable terms. As a matter of fact, we can measure it in relative terms like greater than and less than, that is ranking of preferences based on the degree.
For example, a consumer would prefer cupcakes to bread. In this case, cupcakes would have the first rank while bread would have the second rank. In essence, the measurement here is based on ranking.
Therefore, a consumer can identify two different commodities that will provide him the same level of satisfaction. Out of these two commodities, he may prefer one to the other based on how he ranks them in the order of satisfaction. The ordinal approach does not rank utility on a quantitative basis but on a qualitative basis.
Assumptions of the ordinal theory
Consumers are rational beings, they aim at maximizing their own satisfaction. This is at a given level of income and market price of commodities they consume.
The term is not measurable in quantitative terms, it is measurable in qualitative terms. It is so because a consumer expresses his or her preferences out of a set of similar goods.
Transitive and uniform choice
This theory assumes that a consumer’s choice is usually transitive. That is when a consumer prefers commodity A to commodity B, he would also prefer commodity B to commodity C. He can also prefer commodity A to commodity C as well. On the other hand, if a consumer considers commodity A = commodity B, commodity B = commodity C, he should also consider commodity A = commodity C. Well, uniformity of choice means that if a consumer prefers A to B at a particular time, he does not prefer B to A at another time and does not even consider A and B to be equal.
The theory assumes that consumers never experience an oversupply of commodities. This implies that a consumer does not arrive at a state of satisfaction in the case of any commodity. A consumer always prefers larger amounts of commodities to smaller amounts.
Diminishing marginal substitution rate
The marginal substitution rate refers to the rate at which a consumer is willing to substitute a commodity (X) for another commodity (Y) to maintain his satisfaction level. We can represent the marginal substitution rate as dY/dX.
According to the ordinal theory, the marginal substitution rate continues to decrease as the consumer continues to substitute X for Y.
Concepts of the total, average, and marginal utility
Total utility (TU)
This refers to the total amount/summation of satisfaction a consumer derives from a commodity at a specific time. In another sense, it means the amount of satisfaction a consumer derived from all the goods and services he consumes at that specific time. It is a core concept economists study while they seek to analyze consumer behavior. Generally, economic theories believe that the actions of consumers are based on maximizing total utility. This leads to the purchase of units that consumers perceive to possess the highest satisfaction.
The measurement of total utility is usually in relative units called UTILS.
Total utility keeps on increasing in proportion with an increased intake of a commodity. Even though there is increased satisfaction with an increased intake, this does not continue forever. It gets to a certain stage whereby the utility remains constant with the consumption of an extra unit of a commodity. When there is an extra consumption at this point, the total utility begins to fall. Understanding the nature of the concept, the consumer gets more satisfaction as he keeps consuming a certain commodity. When it goes beyond a certain stage, this satisfaction gets to a point whereby it does not increase again but remains constant. After some time, it starts falling. Under this concept, the satisfaction of a consumer increases at a diminishing rate.
Util in Economic concepts
Util is a unit measurement that economists commonly use to present hypothetical information that relates to satisfaction and a consumer demand theory. The set of economists that use this hypothetical unit is the neoclassical economists. They developed it as a convenient way to explain the concepts of total and marginal utility, and the law of diminishing marginal utility.
Satisfaction is however not measurable in real terms. Because of this, the util represents an actual measurement such as pounds and inches. This unit cannot give an accurate gauge of a consumer’s utility level. The util is frequently used in plural form (utils). This unit seems to display the actual values of utility but these actual values are hypothetical.
Average utility (AU)
This refers to the amount of satisfaction a consumer derives per unit of a commodity he consumed. That is the satisfaction a consumer derives per unit of consumption. We arrive at average utility by dividing the total utility by the units of commodity consumed.
Marginal utility (MU)
This refers to an extra unit. It is the additional satisfaction a consumer derives after consuming an extra unit of a commodity. We can also refer to it as the amount of satisfaction a consumer lost as a result of giving up a unit of the commodity. The summation of all the marginal utilities of a commodity is equal to the total utility of the commodity. We can refer to marginal utility as the utility derived from an added intake of a commodity.
The more units an individual consumes, the less the marginal utility becomes. When TU is at its maximum, the TU becomes zero. when TU begins to fall, the marginal utility becomes negative.
Utility maximization and the rational choice theory
A consumer always wants to achieve the highest level of satisfaction from the limited amount of resources he has. His interest is in maximizing the total satisfaction he derives from his purchases. In a given economic situation, a consumer strives towards making himself as better off as possible.
He can maximize his satisfaction by reducing his expenses on certain commodities that do not yield high satisfaction and increase his expenses on those commodities that give him a higher level of satisfaction.
A consumer who aims at gaining maximum satisfaction will allocate his income between commodities such that the satisfaction he derived from the last unit of money spent on each commodity is equal.
Economists study total utility alongside the theory of rational choice and the law of diminishing marginal utility. The rational choice states that every consumer seeks to maximize his satisfaction with each consumption unit. The theory of consumer behavior and the demand theory propose that the actions of consumers are passionate towards utility maximization. This is by attempting to derive the highest satisfaction possible in the most affordable way.
The concept of origin
Origin means the smallest quantity of a commodity a consumer must consume before it will be able to yield any satisfaction. For example, a spoon of a meal cannot give any satisfaction to someone hungry. The minimum quantity of a meal which one has to take before he can start getting satisfaction varies among individuals, times, and places.
The concept of independent utilities in Economics
The concept assumes that every commodity a consumer consumes is independent of another. It means that the MU of one commodity has does not have any relationship with the MU of another commodity. It also assumes that the satisfaction of a particular consumer does not affect that of another.
The law of diminishing marginal utility
The law states that the satisfaction a consumer gains from an additional unit of a commodity diminishes. That is, as a consumer acquires a larger quantity of a commodity, its MU decreases. In other words, the satisfaction consumer derives from a commodity decreases as the consumption of that commodity increases.
For example, if someone is thirsty, he’s likely to rush a cup of water. The first cup of water possesses a higher level of satisfaction than subsequent ones. When this person keeps drinking more cups of water, he begins to get tired of it. That is when he reaches the point of satiety, the MU is zero. At this point, the person (consumer) is perfectly satisfied, he does not derive any additional satisfaction. If this person goes further to take another cup of water, his MU becomes negative.