The Utility Approach

What Is Utility?
Utility is a term in economics that refers to the total
satisfaction received from consuming a good or
service. Economic theories based on rational choice
usually assume that consumers will strive to maximize
their utility. The economic utility of a good or service is
important to understand, because it directly influences
the demand, and therefore price, of that good or
service. In practice, a consumer's utility is impossible
to measure and quantify. However, some economists
believe that they can indirectly estimate what is the
utility for an economic good or service by employing
these two model-
1. Cardinal Utility Approach
2. Ordinal Utility Approach
Understanding Utility
• The utility definition in economics is derived from the concept
of usefulness. An economic good yields utility to the extent to
which it's useful for satisfying a consumer’s want or need.
Various schools of thought differ as to how to model economic
utility and measure the usefulness of a good or service. Utility
in economics was first coined by the noted 18th-century Swiss
mathematician Daniel Bernoulli. Since then, economic theory
has progressed, leading to various types of economic utility.

KEY TAKEAWAYS
• Utility, in economics, refers to the usefulness or enjoyment a
consumer can get from a service or good.
• Economic utility can decline as the supply of a service or good
increases.
• Marginal utility is the utility gained by consuming an additional
unit of a service or good.
Definition of Cardinal Utility
• The notion of Cardinal utility was formulated by
Neo-classical economists, who hold that utility is
measurable and can be expressed quantitatively or
cardinally, i.e. 1, 2, 3, and so on. The traditional economists
developed the theory of consumption based on cardinal
measurement of utility, for which they coined the term ‘Util‘
expands to Units of utility. It is assumed that one util is
equal to one unit of money, and there is the constant utility
of money.

• Further, it has been realised with the passage of time that

the cardinal measurement of utility is not possible, thus less
realistic. There are many difficulties in measuring utility
numerically, as the utility derived by the consumer from a
good or service depends on a number of factors such as
mood, interest, taste, preferences and much more.
Definition of Ordinal Utility
• Ordinal Utility is propounded by the modern economists, J.R. Hicks,
and R.G.D. Allen, which states that it is not possible for consumers to
express the satisfaction derived from a commodity in absolute or
numerical terms. Modern Economists hold that utility being a
psychological phenomenon, cannot be measured quantitatively,
theoretically and conceptually. However, a person can introspectively
express whether a good or service provides more, less or equal
satisfaction when compared to one another.

• In this way, the measurement of utility is ordinal, i.e. qualitative,

based on the ranking of preferences for commodities. For example:
Suppose a person prefers tea to coffee and coffee to milk. Hence, he
or she can tell subjectively, his/her preferences, i.e. tea > coffee > milk
Key Differences Between Cardinal and Ordinal Utility
The following points are noteworthy so far as the difference between cardinal
and ordinal utility is concerned:

• Cardinal utility is the utility wherein the satisfaction derived by the

consumers from the consumption of good or service can be measured
numerically. Ordinal utility states that the satisfaction which a consumer
derives from the consumption of product or service cannot be measured
numerically.
• Cardinal utility measures the utility objectively, whereas there is a
subjective measurement of ordinal utility.
• Cardinal utility is less realistic, as quantitative measurement of utility is not
possible. On the other end, the ordinal utility is more realistic as it relies on
qualitative measurement.
• Cardinal utility, is based on marginal utility analysis. As against this, the
concept of ordinal utility is based on indifference curve analysis.
• The cardinal utility is measured in terms of utils, i.e. units of utility. On the
contrary, the ordinal utility is measured in terms of ranking of preferences of
a commodity when compared to each other.
• Cardinal utility approach propounded by Alfred Marshall and his followers.
Conversely, ordinal utility approach pioneered by Hicks and Allen.
The Definition of Total Utility
If utility in economics is cardinal and measurable,
the total utility (TU) is defined as the sum of the
satisfaction that a person can receive from the
consumption of all units of a specific product or
service. Using the example above, if a person can
only consume three slices of pizza and the first slice
of pizza consumed yields ten utils, the second slice
of pizza consumed yields eight utils, and the third
slice yields two utils, the total utility of pizza would
be twenty utils.
The Definition of Marginal Utility
Marginal utility (MU) is defined as the additional
(cardinal) utility gained from the consumption of one
additional unit of a good or service or the additional
(ordinal) use that a person has for an additional unit. For
example, if the economic utility of the first slice of pizza
is ten utils and the utility of the second slice is eight utils,
the MU of eating the second slice is eight utils. If the
utility of a third slice is two utils, the MU of eating that
third slice is two utils. In ordinal utility terms, a person
might eat the first slice of pizza, share the second slice
with their roommate, save the third slice for breakfast,
and use the fourth slice as a doorstop.
 Basic Assumptions of Utility Approach
1. Rationality: The consumer aims at the
maximization of his utility
2. Cardinal utility:
3. Constant MU of money
4. Diminishing MU
5. the total utility of a basket of goods depends on
the quantities of individual commodities. If there are
n commodities in the bundle with quantities x1,
x2………xn, the TU is U=f(x1, x2…xn)
 Equilibrium of the consumer
• We begin with the simple model of a single
commodity x.
• The consumer can either buy x or retain his
money income Y.
• Under these conditions, the consumer is in
equm when the MU of x is equal to its market
price. Symbolically: Mux = Px.
• If Mux>Px, the consumer can increase his
welfare by purchasing more units of x.
• If MUX<PX, the consumer can increase his
total satisfaction by cutting down the quantity
of x and keeping more of his income unspent.
• Therefore, he attains the maximization of his
utility when Mux=Px.
• If there are more commodities, the condition
for the equilibrium of the consumer is the
equality of the ratios of the MU of the
individual commodities to their prices.
• Mux/Px=Muy/Py……………Muz/Pz.
• The utility derived from spending an
additional unit of money must be the same for
all (alternative Mahmud!) commodities.
• If the consumer derives greater utility from
any one commodity, he can increase his
welfare by spending more on that commodity
and less on others, until the above equilibrium
condition is fulfilled.
 Example of DMU
• No. of units Total utility Marginal utility
• 1 10 10
• 2 18 8
• 3 24 6
• 4 29 5
• 5 33 4
• 6 33 0
• 7 28 -5
 Example Law of Equi Marginal Utility
• No of Units Mux Mux/Px Muy Muy/Py
• 1 30 30/3=10 20 20/2=10
• 2 27 27/3= 9 16 16/2=8
• 3 21 21/3=7 12 12/2=6
• 4 15 15/3=5 8 8/2=4
• 5 9 9/3= 3 4 4/2=2
• 6 6 6/3= 2 2 2/2=1
• If the consumer has a total of Tk.38 (28
Mahmud!) and if the price of good X is Tk 3
per unit and price of good Y is Tk.2 per unit,
then the consumer maximizes his satisfaction
by consuming 6 units of X and 5 units of Y.
 Indifference curve analysis.
1. Rationality
2. utility is ordinal
3. diminishing marginal rate of substitution: preferences
are ranked in terms of ICs, which are assumed to be
convex to the origin. This implies that the slope of ICs
decreases. The slope of IC is called the MRS.
• MRSx,y=The MRS of x for y is defined as the no. of
units of commodity y that must be given up in
exchange for an extra unit of commodity x so that the
consumer maintains the same level of satisfaction.
4. The total utility of the consumer depends on the
quantities of the commodities consumed: U=f(q1,
q2,……..qn)

5. Consistency and transitivity of choice: it is assumed

that the consumer is consistent in his choice; that is, if in
one period he chooses bundle A over B, he will not
choose B over A in another period if both bundles are
available to him. The consistency assumption may be
symbolically written as follows: if A> B, then B> A cannot
happen.
• Similarly, if it is assumed that consumer’s
choices are characterized by transitivity: if
bundle A is preferred to B and B is preferred to
C, then bundle A is preferred to C.

• If A>B and B>C, then A>C.