- Utility measures the "usefulness" of a thing realtive to another thing;
- It's a subjective measurement with varying parameters;
- It allows economists to anticipate human behaviour.
The central idea of economics is how we deal with scarcity.
The question is, how do we fulfil our endless desires with our limited resources? The answer is... we can't. Instead, we have to make decisions about what is most useful to each of us as individuals.
But we need a way to measure how useful something is compared to something else. We need to be able to compare apples to oranges.
That's what utility is: a measure of how useful something is to you versus something else.
Utility could be how much you enjoyed the last movie you saw, how much you like where you live, or anything else. We can measure the utility of any object or situation, it doesn't have to be monetary.
Utility and decision making
Whenever you make a decision, think about it as the comparison between utility gained from doing one option over the other(s).
You go to work because you gain more utility from work (likely in the form of a wage), than you do staying at home.
The reason this is important for decision making relates to scarcity. If things weren't scarce or difficult to find, we wouldn't need to measure how useful they were.
Everyone could have whatever they wanted, whenever they wanted to. There would be no reason to measure the utility gained between choices.
You could eat your cake and have it, too.
Sadly we do have to decide. So utility gives us a way to measure how we allocate resources in a way that maximises our happiness.
By that reasoning, if everyone is making decisions to maximise their own utility, society is allocating resources in the most efficient way possible.
As long as you believe maximising individual utility is the most efficient use of resources.
Utility is subjective
Utility is a quantitative measure and economists give each choice a number. This is called a "util".
However, utils are only useful when compared to one another.
If the utility of catching the bus is 10 and the utility of getting on a train is 20, we can only say that transportation by train has a higher utility.
We can't say that you get twice the utility from the train trip. Utility isn't a quantity, it's more a way of comparing a relationship.
Let's go through another example.
Say you wake up in the morning and you can have either a chocolate bar or eggs for breakfast, and you decide on the chocolate bar.
In this example, what is better for your health is not reflected in its utility. It's a flexible concept with parameters that are unique to the situation.
Maybe you love chocolate and hate eggs? If so, you gain more utility from eating the chocolate bar for breakfast, even though chocolate is worse for your health than eggs.
However, if you cared about nutritional quality of your food over taste, you'd opt for eggs and they would have greater utility for you.
When we measure utility, we assume that you have taken all relevant things into account, so when you choose the chocolate bar over the eggs, you're making a rational decision given your parameters, if the decision might be worse on another scale.
You already understand utility
Utility is how much you value a particular good over another.
It depends on you as an individual, there is no universal measurement for the utility of an apple, it's relative to you.
You already understand utility because it's central to how you reason. Say you love sushi and your friend hates it.
Sushi has a utility of 1,000 for you and -100 for your friend.
It may sound pointless to put a numerical value to, because of how abstract it is, but utility is important. It forms the basis of rational choice theory and game theory.
How does utility relate to rationality?
Economists presume all individuals are rational, but what economists think of as rational may not be what you think is rational, so let's hash it out.
A rational person is a person who, when given two choices, maximises their own utility. They pick what they prefer.
Given utility takes into account every assumption (think back to the chocolate bar versus eggs example), this isn't hard to agree with. That is, it's not hard to believe a person will choose what they prefer.
Economists aren't saying you will use sophisticated decision making methods that involve qualitative and quantitative ideas to determine the best course of action for each decision. They are saying you will pick what you prefer the most, not what is best for you on objective criteria.
This may be a trivial assumption but it is a fundamental axiom of economics (let's ignore behavioural economics for now).
By accepting the assumption that people are rational, we can model human behaviour and decision making. Without rationality it's hard, if not impossible to say what a person will pick when presented with options.
If a person is irrational, they may pick sushi even if they hate it, to extend from the example above.
You'll be better off for it
Microeconomic theory says an individual is "better off" when they make their preferred choice (the choice with greater utility). That is, they make the choice that increases their total utility.
This means that total utility is the sum of all utility you gain from all goods and services consumed. Therefore total utility is directly related to how much you consume. The more you have the higher the total utility.
However, as utility is relative, the utility you gain from something can decrease as you gain more of it. This is called the law of marginal utility. Marginal utility is the additional satisfaction you gain from increased consumption. A good way to remember is this is to think about the margin of a page, it's the outside.
Intuitively you know adding a little to a lot doesn't change much. To make this idea concrete, let's go through an example.
Say you have $5 in your bank and you receive a payment of $5,000 into your account. Your total utility has probably increased by a lot.
What about if you had $5 million? That $5,000 probably isn't changing your total utility by much.
After a while the marginal utility you gain decreases and total utility increases at a slower pace.
The law of diminishing marginal utility will help you understand the law of demand and why the demand curve has a negative slope.
The less you have, the more you gain from each additional unit.
Whenever the marginal utility you gain from a good or service is at its highest is when you are willing to pay the most for it.
Imagine you're in the desert, how much would you be willing to pay for a bottle of water?
But what about if you were in a freshwater pond, where you could drink from the water safely? Now it's probably worth nothing.
You are willing to pay more when the supply is low because the marginal utility you gain from water in the desert in enormous.
The inverse is true because in the second example the marginal utility you gain is nothing.
Prices are at their lowest when the marginal utility gained is at its lowest, and highest when marginal utility is at its highest.