Lesson 1: Utility Theory
Video Lesson:
Competency (MLC)
Dear learner,
By the end of this lesson, you will be able to:
- Explain cardinal utility
- Define the term utility, Discuss relativity of utility
- Compute total utility, Calculate marginal utility and State law of diminishing marginal utility
Brain Storming Questions
- Why do you buy goods and services?
- How do you measure the satisfaction level (utility) that you get from Consuming goods and services?
Key Terms
- Commodity
- Satisfaction
- Utility
- Cardinal utility
A commodity is a basic good or raw material, like oil, gold, or wheat, that is standardized and interchangeable.
Satisfaction is the fulfillment or pleasure derived from consuming goods or services. It is measured as utility, reflecting the level of happiness or benefit gained.
Utility is the satisfaction or benefit gained from consuming goods or services.
Cardinal utility is the concept that satisfaction from consumption can be measured in exact numbers. It allows precise comparison of utility levels between choices.
1.1 Introduction
A consumer is a decision making unit (an individual or a household) who uses or consumes a commodity or service. The theory of consumer behavior is concerned with how a consumer decides on the basket of goods and services he/she consumes in order to maximize his/her satisfaction. In this unit, we will discuss how the consumer decides to spend his/ her income on different goods.
The theory of consumer behavior, set out with the following important assumptions;
- The consumer has a limited income.
- The consumer is assumed to be rational.
Given the consumer’s income and the market prices of the commodities, he/she spends the income on goods and services that give the highest possible satisfaction or utility. The consumer has relevant information to make a decision, is aware of his or her income, and is aware of the commodities available and their prices.
1.2 The Concept of Utility
In our everyday lives, we buy different goods and services for consumption. Utility is the level of satisfaction or pleasure derived from the consumption of a good or service. Thus, utility is the power of a commodity to satisfy human wants. For example, bread has the power to satisfy hunger, while water quenches our thirst.
In defining utility, it is important to bear in mind the following points:
Relativity of Utility:
- The utility of a commodity is subjective to a person’s needs. It is not absolute (objectively determined).The same commodity provides different utilities to different consumers. For example, non-smokers do not derive any utility from cigarette.
The utility of a product can be different at different places and times
- For example, the utility that we get from wearing jackets during the cold season is not the same as during the hot season. For the same consumer, utility varies from unit to unit, from time to time, and from place to place. For example, the utility we get from drinking tea early in the morning may be different from the utility we get during lunch time.
‘Utility’ and ‘usefulness’
- Are not synonymous: usefulness is the concern of a product whereas utility is the concern of the consumer.
Approaches to measuring Utility:
Since utility is a qualitative concept, it is difficult to measure quantitatively, but economists try to quantify it in two different ways: cardinal utility and ordinal utility.
1.3 The Cardinal Utility Theory
To get a higher level of satisfaction, the consumer must be able to compare the utility of the various baskets of goods that can be bought with the available income. According to Cardinal Utility theory, utility is measurable like weight, height, and temperature, and they suggested a unit of measurement of satisfaction called ‘utils’. The Cardinal School postulated that utility can be measured in monetary units (i.e., by the amount of money that the consumer is willing to pay for another unit of a commodity) or by subjective units called ‘utils’. Thus, the school assumes that the level of utility can be expressed in numbers.
1.3.1 Assumptions of Cardinal Utility Theory
The consumer is Rational:
The main objective of the consumer is to maximize his/her satisfaction given his/her limited budget or income. Thus, in order to maximize his/her satisfaction, the consumer has to be rational.
Cardinal Utility:
Utility is a cardinal concept, which means the utility of each commodity is measurable, with the most convenient measure being money.
Constant Marginal Utility of money:
The utility that one derives from each successive unit of money income remains constant.
Diminishing Marginal Utility:
The utility gained from the successive units of a commodity diminishes. In other words, the marginal utility of a commodity diminishes as the consumer consumes larger quantities of it. This is the law of diminishing marginal utility.
The total utility of a basket of goods:
Depends on the quantities of the individual commodities. If there are n commodities in the bundle with quantities X1 , X 2 ,…X n , the total utility is given by TU = f ( X1 , X 2; ……Xn).
1.3.2 Measurement of Utility
Total Utility (TU):
Refers to the total amount of satisfaction a consumer gets from consuming or possessing some specific quantities of a commodity (X) at a particular time. As the consumer consumes more of a good (X) per time period, his/her total utility increases. However, there is a saturation point for that commodity after which the consumer will not be capable of enjoying any greater satisfaction from it. Therefore, TUn refers to the total utility derived from consuming n units of a commodity X.
Marginal Utility (MU):
Refers to the additional utility obtained from consuming an additional unit of a commodity. In other words, marginal utility is the change in total utility resulting from the consumption of one more unit of a product per unit of time. Mathematically, the formula for marginal utility is:
Suppose Beka gets 10 utils of total utility by consuming 2 quantities of orange, and his total utility increases to 12 utils as he consumes 3 quantities of orange. Thus, consumption of the 3rd quantity of orange has caused total utility to increase by 2 utils (12 utils minus 10 utils). Therefore, the marginal utility of the 3rd orange is 2 utils.
Figure 1.1 shows that total utility initially increases, and reaches ‘its pick (saturation) point’. This saturation point indicates that by consuming 7 quantities of banana, the consumer attains its highest satisfaction level of 37 utils. However, consumption beyond this point results in dissatisfaction, because consuming the 8th and more quantities of banana brings negative additional utility.
On the other hand, the marginal utility continuously diminished and became zero when the total utility reached maximum, and then became negative as consumption increased beyond the saturation point of the total utility.
Figure 1.1: Relationship between total utility and marginal utility
1.3.3 The Law of Diminishing Marginal Utility (LDMU)
Do you get the same utility from drinking the first glass of water and the second glass of water? The utility that a consumer gets by consuming a commodity for the first time is not the same as the consumption of the good for the second, third, fourth, etc.
LDMU is central to the cardinal utility analysis of consumer behavior. This law states that as the quantity consumed for a commodity increases over a unit of time, the utility derived by the consumer from the successive units goes on decreasing, provided the consumption of all other goods remains constant. The above(table 1.2) shows a numerical illustration of the law of diminishing marginal (LDMU). Here, TU increases with an increase in consumption of banana, but at a decreasing rate. It means that MU decreases with a n increase in consumption.