Utility – The Basis of Choice

M2 L4
Dr. Mayeth T. Salandanan
Pre-task
Slido.com
What do you know about the term utility?
 Objective

• To understand the concept of utility.

• To know when to allocate income to maximize utility.
• To learn diminishing marginal utility.
• To discern income and substitution effect.
 Introduction
• Utility means the degree of pleasure or satisfaction (or removed
discomfort) that an individual receives from an economic act. An
example would be a consumer purchasing a hamburger to alleviate
hunger pangs and to enjoy a tasty meal, providing her with some utility.

• All economists would agree that the consumer has gained utility by
eating the hamburger. Most economists would agree that human beings
are, by nature, utility-maximizing agents; human beings choose between
one act, or another based on each act's expected utility. The
controversial part comes in the application and measurement of utility.
 Origin of Utility

• The concept of utility was introduced by Stanley Jevons.

• Utility is the want-satisfying power of a commodity.
• It is the satisfaction, actual or expected, obtained from the consumption
of a commodity. It differs from person-to-person, place-to-place and
time-to-time.
 Utility : The Basis of Choice

• Utility is a term used to determine the worth or value of a good

or service.
• More specifically, utility is the total satisfaction or benefit derived
from consuming a good or service.
• Economic theories based on rational choice usually assume
that consumers will strive to maximize their utility.
 Why is the concept of utility important?
• The utility function is essential because it relates heavily to the law of supply
and demand and helps explain consumer behavior through decision theory.
• 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.
• Rational consumers purchase things because those goods offer some form of
value to them.
• In practice, a consumer's utility is usually impossible to measure or quantify.
• However, some economists believe that they can indirectly estimate what is
the utility of an economic good or service by employing various models.
 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.
• Using the same 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.
 Points to Remember

• Ordinal utility refers to the concept of one good being more useful or
desirable than another.
• Cardinal utility is the idea of measuring economic value through imaginary
units, known as "utils."
• Marginal utility is the utility gained by consuming an additional unit of a
service or good.
• Total utility is the sum of the satisfaction that a person can receive from the
consumption of all units of a specific product or service.
• Economic utility can be defined as the total amount of satisfaction that
someone experiences when they consume a particular product or service. It
helps measure how much fulfillment someone requires in order to satisfy a
particular need or want.
 Diminishing Marginal Utility

• Austrian economist Carl Menger, in a discovery known as the marginal

revolution, used this type of framework to help him resolve the diamond-
water paradox that had vexed many previous economists.
• Because the first available units of any economic good will be put to the
most highly valued uses, and subsequent units go to lower-valued uses,
this ordinal theory of utility is useful for explaining the law of diminishing
marginal utility and fundamental economic laws of supply and demand.
Diminishing Marginal Utility and the downward sloping curve

• According to the law of diminishing marginal utility, as the quantity of a

good with a consumer increases marginal utility of the goods to him
expressed in terms of money falls. In other words, the marginal utility
curve of goods is downward sloping.
• In other words, the consumer will be in equilibrium in respect of the
quantity of the goods purchased where marginal utility of the goods
equals its price. His satisfaction will be maximum only when marginal
utility equals price. Thus, the ‘marginal utility equal’s price’ is the
condition of equilibrium.
 Diminishing Marginal Utility
• When the price of a goods falls,
downward sloping marginal utility
curve implies that the consumers
must buy more of the good so
that its marginal utility falls and
becomes equal to the new price.
It, therefore, follows that the
diminishing marginal utility curve
implies the downward-sloping
demand curve, that is, as the
price of the goods falls, more of it
will be bought.
 Diminishing Marginal Utility

• In this figure the curve MU represents the diminishing marginal utility of

the goods measured in terms of money. Suppose the price of the goods
is OP. At this price the consumer will be in equilibrium when he
purchases OQ, quantity of the goods, since at OQ, the marginal utility is
equal to the given price OP’.
• Now, if the price of the goods falls to OP’, the equality between the
marginal utility and the price will be disturbed. Marginal utility Q, E at the
quantity OQ, will be greater than the new price OP’, the consumer must
buy more of the goods, it is evident from Fig. 5 that when the consumer
increases the quantity purchased to OQ, the marginal utility of the goods
falls and becomes equal to the new price OP’.
 Diminishing Marginal Utility

• It is thus, clear that when the price of the goods falls, the consumer buys
more of the goods so as to equate the marginal utility to the lower price.
It, therefore, follows that the quantity demanded of a goods varies
inversely with price; the quantity bought rises when the price falls and
vice versa, other things remaining the same. This is the famous
Marshallian Law of Demand. It is now quite evident that the law of
demand is directly derived from the law of diminishing marginal utility.
• The downward-sloping marginal utility curve is transformed into the
downward-sloping demand curve. In Fig. 1 (where price is also
measured on the Y-axis) marginal utility curve MU becomes the demand
curve. It follows, therefore, that the force working behind the law of
demand or the demand curve is the force of diminishing marginal utility.
 How Do You Measure Economic Utility?

• While there is no direct way to measure the utility of a certain good for
an individual consumer, it is possible to estimate utility through indirect
observation.
• For instance, if a consumer is willing to spend $1 for a bottle of water but
not $1.50, economists can safely state that a bottle of water has
economic utility somewhere between $1 and $1.50. However, this
becomes difficult in practice because of the number of variables that are
present in a typical consumer's choices.
 Util as a measurement

• A “util” is an artificial measure of a consumer's satisfaction from

consuming a good. Economists measure total utility, or the total number
of utils, a consumer receives from consuming a quantity of a good.
Marginal utility is the additional utility a consumer receives from
consuming an additional unit of a good.
 4 Types of Utility
• Form utility - created by the design of the product or service itself. The
more precisely a good or service is targeted towards customer needs
and desires, the higher its perceived added value (i.e., form utility) will
be. In other words, form utility is obtained by transforming customer
needs into products or services.
• Place utility - can be obtained through the process of making a good or
service more easily available to potential customers. The easier it is to
purchase a product, the more attractive it becomes. Thus, place utility
has a lot to do with distribution channels and the physical locations at
which goods or services are sold.
 4 Types of Utility
• Time utility - created by providing easy availability of a good or service
at the time when customers need or want it. The more easily and quickly
a product can be purchased (and used) at that time, the higher its
perceived time utility is. In addition to that, time utility is always high in
times of scarcity.
• Possession utility - describes the benefits that can be derived from
owning and using a specific product. The more “useful” a product is to
an individual, the higher its possession utility will be.
 How do you allocate income to maximize utility?

• Utility maximization – states that to obtain the greatest utility the

consumer should allocate money income so that the last dollar spent on
each good or service yields the same marginal utility.
• It is the concept that individuals and firms seek to get the highest
satisfaction from their economic decisions.
• For example, when deciding how to spend a fixed some, individuals will
purchase the combination of goods/services that give the most
satisfaction.
 What is Utility Maximization?

• Utility maximization is a strategic scheme whereby individuals and

companies seek to achieve the highest level of satisfaction from their
economic decisions.
• For example, when a company’s resources are limited, management will
implement a plan of purchasing goods or services that provides the
maximum benefit.
Thanks for listening!