What is Utility?
In the field of economics, utility (u) is a
measure of how much benefit consumers
derive from certain goods or services.
From a finance standpoint, it refers to how
much benefit investors obtain from
portfolio performance.
While it may be intuitive to assume that all
investors would like to achieve very high
returns, it is important to realize that such
returns typically require the investor to
take on a lot of risks. Risk and return are
trade-offs and follow a linear relationship.
High-risk investments present a high
likelihood of an investor losing all his/her
money. Having a solid understanding of
one’s u of money can help investors make
investment decisions that are more
to their risk attitudes and investme|
strategies.How is Utility Measured?
Since the u scale varies greatly between
individuals, and as individuals have
different u functions, it is quite difficult to
quantify u. However, it is sometimes
possible to use dollars as a quantitative
measure of u. Consider the following
example:
Ben is considering buying a new house.
After conducting extensive research, Ben
has narrowed down his options to t
following:Home A Clute)
Type
_ | Apartment _ | Detached House
Bedrooms 1 5
(Bathrooms | 1 3
Size (square feet) ; | 700 | 4000
(Location | Downtown | Countryside
Price | $2,000,000 ~—| ~—«$500,000
From a value standpoint, Home Bisa
better deal since it provides more benefit
as a standalone entity. However, Ben
works downtown and thus decides to pay
$2 million for Home A instead. In such a
case, we can say that Ben’s utility of living
downtown is $1.5 million (the premium
over Home B).
In certain cities, there may be many people
like Ben that would pay a large premium to
live in a certain area. In such cases, studies
can be conducted to further under:
consumer behavior and draw additilive in a certain area. In such cases, studies
can be conducted to further understand
consumer behavior and draw additional
insights.
Marginal Utility
Marginal utility refers to how much
incremental u an individual derives from
obtaining one additional unit of a certain
good or service. Consumers derive
decreasing marginal u from goods and
services available in an economy. This
means that after having a certain amount
of a particular good or service, the u of
acquiring one more unit of the
good/service falls.
A recent study has found that peo
earning $95,000 per year derive jusA recent study has found that people
earning $95,000 per year derive just as
much u from their salary as people earning
$200,000 per year. This illustrates the
concept of decreasing marginal u; after
$95,000, individuals begin to value other
things (such as time) much more than
money.
Types of Utility Curves
Generally speaking, there are three types
of utility curves that explain the
relationship investors have with risk.
Type | - Risk Averse
This type of utility trend is what m
individuals experience, according topis type vl UtiILy LITIIU ID WEIGEL HHUSt
individuals experience, according to the
study cited above. From a conceptual
standpoint, graphing this type of utility
would give us the following:
Utility
RiskAs the investor takes on more risk (and
thus the possibility of greater returns),
they will start to have a smaller and smaller
desire to take on further risk.
Type II - Risk Neutral
This attitude towards risk would be
perfectly linear and not face changes in
marginal utility. The graph below illustrates
this relationship:Utility
Risk
In practice, such an investor would
continuously take on more risk since this
will result in more utility. This type of
investing behavior is quite rare.Type III - Risk Loving
This attitude towards risk would be
exponential, meaning that this investor
experiences increasing marginal utility.
The graph below illustrates this
relationship:
Utility