Utility in Microeconomics: Origins, Types, and Uses

Utility is a loose and sometimes controversial topic in microeconomics. Generally speaking, utility refers to 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.

The Origins of Utility

The development of utility theory begins with a logical deduction. Voluntary transactions only occur because the trading parties anticipate a benefit (ex-ante); the transaction wouldn't happen otherwise. In economics, "benefit" means receiving more utility.

Economists also say that human beings rank their activities based on utility. A laborer chooses to go to work rather than skip it because he anticipates his long-run utility to be greater as a result. A consumer who chooses to eat an apple rather than an orange must value the apple more highly, and thus anticipates more utility from it.

Utility took hold in economics during the marginalist revolution, which tried to formalize and mathematize economics based on incremental changes. Because mainstream economists today have adopted a rational actor perspective, where their models assume that individuals are driven entirely by self-interest utility maximization, the concept of utility has been made prominent in microeconomics.

Cardinal and Ordinal Utility

The ranking of utility is known as an ordinal utility. It is not a controversial topic; however, most microeconomic models also use cardinal utility, which refers to measurable, directly comparable levels of utility.

Cardinal utility is measured in units called "utils" to transform the logical into the empirical. The ordinal utility might say that ex-ante, the consumer prefers the apple to the orange. Cardinal utility might say that the apple provides 80 utils while the orange only provides 40 utils. Economists sometimes employ what is known as an indifference curve to elucidate the cardinal utility of two or more goods in graphical form.

Marginal Utility

Marginal utility looks at the added satisfaction that somebody gains (or loses) from consuming just one additional unit of a good or service. It measures how much an individual's total utility (such as their satisfaction or happiness) changes when they consume a little more of a particular item.

Economists use the concept of marginal utility to explain how consumers make choices to maximize their total utility, given their preferences and budget constraints. In theory, consumers will allocate their income to goods and services in a way that maximizes their overall satisfaction. For instance, if you have disposable income of $100 this month, it is most likely that you will allocate those funds to maximizing whatever increases your utility.

A more robust example of marginal utility is usually done with food. For instance, imagine you take a seat at your favorite hamburger restaurant.

• Assuming you're hungry, eating one hamburger when hungry provides a lot of utility. You received utility as you're now less hungry than before.
• Eating a second hamburger perhaps gives a bit less satisfaction. You may have still been hungry, but you were not as hungry as before.
• Eating a third hamburger may even lower utility since now you're already quite full. The marginal utility of this third hamburger may be low.
• Eating a fourth hamburger may make you sick. You're full at this point and don't actually want to eat it, so you may actually have negative marginal utility with the fourth hamburger.

The Law of Diminishing Marginal Utility

In the example above, notice how the amount of utility you received for each additional unit of consumption went down. This is the law of diminishing marginal utility. The law of diminishing marginal utility describes this effect, where adding one more unit of something typically results in fewer and fewer gains in utility for the consumer.

In the context of consumption, marginal utility represents the additional satisfaction or happiness a person gets from consuming one more unit of a good or service. Economists assume that individuals are rational and seek to maximize their overall satisfaction or utility from their consumption choices. Therefore, when faced with limited resources, individuals will allocate their resources (money) in such a way that the marginal utility per dollar spent is roughly equal for all goods and services. As consumption of one good increases, the utility of consuming that good again may decrease.

The concept of diminishing marginal utility is central to the analysis of consumer equilibrium. To maximize their overall satisfaction within their budget constraints, consumers will allocate their spending so that the marginal utility of the last unit of each good consumed is equal to the price (or opportunity cost) of that good. Once the marginal utility drops below this level, it no longer makes sense for the consumer to pursue marginal units of the good.

The law of diminishing marginal utility helps explain why people diversify their consumption across a variety of goods and services rather than consuming massive quantities of a single item. It also helps explain why prices are necessary in a market economy to allocate resources efficiently, as the price reflects the relative scarcity of a good and helps consumers make choices based on marginal utility. For example, after consuming one apple, a consumer may be more likely to elect to eat a different fruit next time as the utility across products may feel greater.

The Usefulness of Utility

Utility theory has been quite useful in understanding the economic action of individuals, households, and firms—but only in broad strokes. In reality, people may eat a third hamburger for reasons that elude the rational actor assumption of standard economic models. For instance, a leftover hamburger may be considered wasteful food, and in order to prevent waste, it is eaten. This more ethical or qualitative evaluation of "utility" is difficult to capture in mathematical models or formulae.

Behavioral economics has also revealed time and again how economic actors deviate from rational expectations in everyday life and fail to maximize utility. Moreover, empirical work shows that people have inconsistent preferences. While somebody may prefer apples to oranges this week, next week oranges may be what is craved. As a result of these and other factors, some have questioned the usefulness of utility in practice.

Utility and Indifference Curves

There's different ways to depict utility, and one of those is an indifference curve. An indifference curve is a fundamental graphical tool in economics used to represent a consumer's preferences and choices regarding two goods or services. It shows all the combinations of these two items that provide the consumer with the same level of satisfaction or utility. Each curve represents a specific level of utility, and higher curves indicate greater satisfaction.

The shape of an indifference curve is typically convex, sloping downward from left to right. This curve reflects the concept of diminishing marginal rate of substitution, which means that as a consumer moves along the curve, they are willing to trade off fewer units of one good for one more unit of the other because they already have a certain amount of each. This diminishing rate of substitution is a key characteristic of consumer preferences.

The point of tangency between an indifference curve and the consumer's budget constraint represents the optimal consumption choice. At this point, the consumer allocates their income in a way that maximizes their utility, as the consumer considering both the prices of the goods and their budget constraints. Though consumers do not graphically plot their choices before choosing how they consume, economists can collect market data to better understand consumption decisions made especially in parallel with consumer income.

Example of Utility

Let's take a quick look at two very different examples of utility. First, as part of Microsoft's 2022 annual report, the company reports on inventory and how it values the goods it keeps on hand. In the company's annual report, it mentions that it "regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory."

The company continues by stating that "If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue". In this context, Microsoft is stating that they periodically review the aggregate utility or benefit consumers will receive from its goods and adjusts its financial statements accordingly.

In a very different example, a study from China analyzed how the health of an individual affected that person's marginal utility of consumption. In this type of study, utility can be an indicator of not only consumer behavior but of broader trends that may influence consumer trends.

The Bottom Line

Even though no economist truly believes that utility can be measured this way, some still consider utility a useful tool in microeconomics. Cardinal utility places individuals on utility curves and can track declines in marginal utility across time. Microeconomics also performs interpersonal comparisons with cardinal utility. Other economists argue that no meaningful analysis can come out of imaginary numbers and that cardinal utility—and utils—is logically incoherent.