Utility in Economics Explained: Types and Measurement (original) (raw)

What Is Utility?

In economics, 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.

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 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.

Key Takeaways

• Utility, in economics, refers to the usefulness or enjoyment a consumer can get from a service or good.
• Although the concept of utility is abstract, it is a useful way to explain how and why consumers make their decisions.
• "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.

Investopedia / Mira Norian

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.

Ordinal Utility

Early economists of the Spanish Scholastic tradition of the 1300s and 1400s described the economic value of goods as deriving directly from this property of usefulness and based their theories on prices and monetary exchanges.

This conception of utility was not quantified, but a qualitative property of an economic good. Later economists, particularly those of the Austrian School, developed this idea into an ordinal theory of utility, or the idea that individuals could order or rank the usefulness of various discrete units of economic goods.

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.

Cardinal Utility

To Bernoulli and other economists, utility is modeled as a quantifiable or cardinal property of the economic goods that a person consumes. To help with this quantitative measurement of satisfaction, economists assume a unit known as a “util” to represent the amount of psychological satisfaction a specific good or service generates for a subset of people in various situations. The concept of a measurable util makes it possible to treat economic theory and relationships using mathematical symbols and calculations.

However, it separates the theory of economic utility from actual observation and experience, since “utils” cannot actually be observed, measured, or compared between different economic goods or between individuals.

If, for example, an individual judges that a piece of pizza will yield 10 utils and that a bowl of pasta will yield 12 utils, that individual will know that eating the pasta will be more satisfying. For the producers of pizza and pasta, knowing that the average bowl of pasta will yield two additional utils will help them price pasta slightly higher than pizza.

Additionally, utils can decrease as the number of products or services consumed increases. The first slice of pizza may yield 10 utils, but as more pizza is consumed, the utils may decrease as people become full. This process will help consumers understand how to maximize their utility by allocating their money between multiple types of goods and services as well as help companies understand how to structure tiered pricing.

Economic utility can be estimated by observing a consumer's choice between similar products. However, measuring utility becomes challenging as more variables or differences are present between the choices.

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.

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.

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.

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 example, if a consumer is willing to spend 1forabottleofwaterbutnot1 for a bottle of water but not 1forabottleofwaterbutnot1.50, economists can safely state that a bottle of water has economic utility somewhere between 1and1 and 1and1.50. However, this becomes difficult in practice because of the number of variables that are present in a typical consumer's choices.

What Are the 4 Types of Economic Utility?

In behavioral economics, the four types of economic utility are form utility, time utility, place utility, and possession utility. These terms refer to the psychological importance attached to different forms of utility. For example, form utility is the result of the design of a product or service, and time utility refers to the ability of a company to provide services when the customers need them.

How Do You Invest in Utilities?

Utilities are companies that operate in the electric, water, oil, or gas sectors. These companies play a major role in industrial economies and have a total global market capitalization of nearly $6.4 trillion as of 2024. In addition to investing in individual companies, there are also many targeted funds that are invested in a basket of utilities-sector companies.

The Bottom Line

Utility can be used to measure the usefulness of goods and services to consumers. While there are limitations when more variables and differences appear in the market, various types of economic utility continue to be examined. Not only can it help companies with structuring their tiered pricing but it can also help consumers learn how to boost the utility of their purchases.