For the homo economicus utility is to be maximised. Before utility can be maximised it needs to be measured. The utility function needs to be known. But what does that really mean? In all forms of economics the word utility is thrown around, and I have already used it without properly explaining what utility means. Until now.
Utility When you google utility you’ll find the following definitions quite often: 1: the quality or state of being useful. 2: a business that supplies a public service (as electricity or gas) under special regulation by the government.
However useful in day to day life, these definitions have little to do with the economic meaning of the word, despite that its meaning has been derived from the first option provided by dear Merriam and Webster.
Utility in an economic sense was introduced by Daniel Bernoulli. It refers to the total satisfaction received from consuming a good or service. The utility of a good or service is important to understand. As utility is driving the demand and therefore the price of said good or service.
Unfortunately, a consumer's utility is hard to measure. It can be determined indirectly with theories of consumer behaviour. These theories still assume that consumers will strive to maximize their utility. At least, they’ll try to the best of their abilities.
Forms of Utility There are different forms of utility. And since these forms are thrown around without much of an explanation. I will post the most frequently used ones here:
Total Utility: the sum of utility that an individual derives from the consumption of all the units of a given good or service. Say the total experienced utility of three hamburgers eaten. Marginal Utility: the additional utility a consumer derives from the consumption of one additional unit of a good or service. So say, the difference between the utility experienced from eating the third and the utility experienced from eating the second hamburger. Expected Utility: the utility I expect to derive from the consumption of a good or service. Such as the utility I expect to get from eating one hamburger later tonight. Cardinal Utility: the approach to measuring utility by neo-classical economists. Who believe that an individual can know and express the value of his/her utility in numbers. One hamburger gives me a utility of 10. Ordinal Utility: the approach to measuring utility by behavioural economists. Who do not believe that an individual can know and express the value of their utility in numbers. However, the utility derived can be ordered in relative terms. Eating two hamburgers gives me a higher utility compared to only eating one hamburger.
What is a Utility Function? Having established the utility derived from one good, hamburgers in our case, we can do this for many more. Ultimately, we will derive a mathematical function which ranks alternatives according to their utility to an individual. The utility function now measures preferences over a set of goods and services, representing the welfare or satisfaction of a consumer from consuming a certain number of goods. Because satisfaction, happiness and welfare are highly abstract concepts to base utility on, economists measure utility in terms of revealed preferences: by observing consumer choices and creating an ordering of consumption baskets from least desired to the most preferred.
What shape is a Utility Function? Now that we have established our utility function we know everything there is to know about the ranking of our preferences. Until we realise we are not homo economicus and we start taking context into account again.
The utility that most (behavioural) economists are interested in is Expected Utility (EU). This form of utility comes with a certain risk: we haven’t had our good/service yet to derive our utility from. Our good/service might have a temporal delay before it can be consumed. We might not have anything to consume at all! Risk attitude determines how we behave when facing risky choices about future consumption.
Imagine the following scenario: an individual can choose between getting a sum of money without risk (Certainty Equivalent), or can take a gamble with two risky prospects, say: 50% of €0,- and 50% of €1000. It depends on how their risk attitudes shape their expected utility function which choice they will make.
Let’s start easy. The risk neutral individual does not take great notice of risk. For risk-neutral people expected utility is the same as experienced utility. They will calculate the Expected Value (€500) and derive their CE from this. They are completely indifferent between taking the bet or the CE for €500.
A small percentage of people are risk lovers. They love taking risks so much they derive additional utility for choosing a risky prospect. Risk lovers are willing to forgo winnings to engage in risk taking. Their CE has to be quite high (>€500) to make up for the lack of risk associated with choosing this option. The higher their risk-seeking level is, the more they are willing to pay (or forgo) to obtain the risky outcome.
About 75% of people are risk averse. They hate taking risks so much they are willing to pay to not have to take it. As a result, their expected utility is lower than their experienced utility from the money, as it includes risk. Naturally, their CE is lower than the expected value of the gamble (€500).
There are more things that can change utility. One of them is known as discounting, which means to adjust future expected utility (or value) to present utility. This process can be done in various ways and will be explained in a later article. For now, I just want you to think about the many meanings, forms and shapes of utility!
References Merriam-Webster (2018). Utility: https://www.merriam-webster.com/dictionary/utility