Economics Online Tutor

Demand Analysis: Utility

The term utility is used often in economics.  Utility is a concept used to help
explain the choices that consumers make.  This helps to explain demand,
especially the downward slope of the demand curve.

Utility refers to the amount of satisfaction, or happiness, that individuals receive
from the choices that they make.  Each person is unique.  Different people
receive satisfaction for different reasons.  They will make different choices even
if the circumstances are the same.  Because of this, the concept of utility
explains how making different choices can still be consistent with the basic
assumption in economics that people behave rationally.

Utility (satisfaction) comes from more than just financial wealth and material
possessions.  Sure, people can derive satisfaction from wealth accumulation.  
But people also derive satisfaction in other ways.  People may be satisfied
knowing that they are helping others.  Such charity takes many forms, and
involves many choices as well.  People may gain satisfaction from accumulating
many friends, or maybe just having a few very close friends.  Some people gain
more satisfaction from leisure than others.  Many people enjoy hobbies, and
different people are willing to devote different amounts of their time and
incomes to an unlimited number of potential hobbies.  Some people prefer
current consumption while others prefer future financial security.

All of these considerations, and more, contribute to different rational choices
being made by different people.
Since utility comes from the choices that people make, a cost is always involved.  If there were no costs,
then people wouldn't have to make choices.  But when someone decides what to do with a specific time
frame or a specific sum of money, they have to give up using that time frame or that specific sum of money
for a different activity.

The cost of a choice is more than just the amount of money, or time, that has to be spent on that choice.  
The cost of a choice is the amount of satisfaction (utility) that has to be given up because another choice
was not made instead.

This means that the true cost of any choice is its
opportunity cost.  Since choices often involve more than
two options, and only one of the options can be chosen, the opportunity cost is a measure of the utility of
the best alternative to any given choice.  It would not make sense to add up utilities for several options
when only one of them can be chosen.

This concept of measuring opportunity cost brings up another concept in economics: the concept that
utility can somehow be measured.  It is true that people everywhere do not go around all the time
computing a number in order to make the best choice every time that a choice is made.  But people do
make choices because of the way they envision the benefits and costs involved.  Without even realizing
that they are doing so, people are making measurements regarding utility.  Whichever options are
available, people choose the one in which the perceived benefits most outweigh the perceived costs.

Another concept in economics involving utility and choice is that choices do not occur in a vacuum.  
Every choice relates to choices that have been made previously.  Suppose, for example, that you have a
favorite song that you haven't heard in a long time.  Now, suddenly, it has been made available to you so
that you can listen to it as often as you like.  Since you haven't heard it for a long time, you might make it a
priority to listen to it immediately.  All other options that you have for using this time frame will have to

So you listen to it once, and it makes you very happy (you receive a high utility value from this).  You want
to hear it again.  You listen to it a second time immediately after the first time, and the utility is still high.  
But not quite as high as the first time, because you had to wait so long to hear it the first time.  In fact,
every time that you listen to it consecutively, the utility is going to be less than the previous time.

This is the concept of
diminishing marginal utility.  Every time the same option is chosen within a specified
time frame, the utility will be less than the previous time.  Somewhere along the line, with diminishing
marginal utility, the utility received from making the same choice over again will be less than the utility
that could be received from something else, even if that 'something else' initially had a lower utility value.  
You will 'spend' your next choice on something else instead.

As the same choice continues to be made, with less utility received each time, eventually you could end
up actually decreasing your total utility: the last choice gave you a negative amount of utility.  Maybe you
eat so much that you get sick.  When marginal utility becomes negative, this is called

When making choices, the available options might be complicated somewhat because different choices
might involve a different (explicit) cost outlay.  One option might take up more of your time than another
option.  One option might require you to spend more of your income than another option.

For example, suppose you decide to go out to dinner with friends.  You will enjoy going out, enjoying the
company of your friends, so you will be happy (have positive utility) with whatever restaurant choice is
made.  You could go to a fast food restaurant and be happy.  You would be even happier (have more total
utility) going to a fancy restaurant, but it would cost more.  If you spent more for dinner at a fancy
restaurant, you would have less money left over for other things.  So, which option would be better, fast
food or fancy restaurant?

The answer is that you would choose whichever one gives you the most utility per unit of cost.  The value
you place on a fast food meal, divided by its cost, can be compared to the value you place on dining in a
fancy restaurant, divided by its cost.  You would choose the one that gives you the highest value (utility)
per unit of cost.

This concept, maximizing marginal utility per unit of cost, applies as well to a series of choices.  Each
choice depends in part on previous choices.  Each subsequent time that the same choice is made will
provide less total utility than the previous time that particular choice was made (diminishing marginal
utility).  But presumably, the cost will be the same.  Lower benefit, same cost.

Therefore, the marginal utility per unit of cost will change over a series of choices.

In order to maximize total utility from a given budget, the budget will be spent over a series of choices,
each one based on maximizing utility per cost, and each choice giving less utility per cost than the
previous time that choice was made, until the income is spent with the marginal utility per cost for each
option being equal.

This is called
consumer equilibrium, or the equimarginal principle.  Consumer equilibrium can be shown
mathematically as:

MU(A)/P(A) = MU(B)/P(B) = ...MU(X)/P(X)

where A = one option, B = another option, and X represents each additional option to be considered.
All of this talk about utility leads to the reasons behind a downward
sloping demand curve.  Each individual consumer will allocate
income among the various consumer choices in such a way that
the ratio MU/P for each consumer good will be equal.

If the price of one good increases relative to other goods, then the
ratio MU/P will decrease, and the consumer will purchase this good
in a smaller quantity.  If the price of one good decreases relative to
other goods, then the ration MU/P will increase, and the consumer
will purchase this good in a higher quantity.  For each individual
consumer and each individual good, more will be purchased as the
price decreases.  This means that an individual's demand curve for
each good is downward sloping.  Notice that this involves price
changes relative to the prices of other goods.

The market demand curve is simply the sum of all individual
demand curves.  With decreasing marginal utility and consumer
equilibrium, the result is a downward sloping demand curve.
Consumer Surplus:

Consumer surplus measures
the difference between what a
consumer is willing to pay for a
given quantity of a good,
based on its marginal utility,
and the amount that the
consumer actually has to pay
for that quantity, based on the
market price for that good.  
Since marginal utility
decreases with each
additional unit purchased, a
consumer will require a lower
price in order to consume a
larger quantity.
This page, along with additional commentary, was posted on the "Economics
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