Utility Theory: Definition, Examples & Economics

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

This lesson will explain the economic concept of utility and the two ways it is measured. The usefulness of utility in the theoretical derivation of demand curves is also explained.

What is Utility?

When Marie makes her weekly trip to the grocery store, she'll be making many quick decisions about what she buys. She probably has a number in her head that is the most she wants to spend on this trip. That means her objective will be to get the most happiness or satisfaction from every dollar she is going to spend.

What items make you happier at the store? The answer may predict your likelihood of buying them.
grocery cart

We all know that the concept of happiness is impossible to quantify or put into numerical terms, but economists will try anyway! That brings us to the economic concept of utility. Utility is the amount of satisfaction that you will get from the consumption of a product or service.

Economists use an abstract measure for the amount of satisfaction you receive from something, it is called a 'util'. A util is an abstraction because it isn't something in the physical world like an inch or a pound. It is something inside your head, it represents one unit of satisfaction or happiness. You might get 25 utils of satisfaction from eating a bowl of ice cream while someone else would only get 5.

Cardinal Utility

So how is Maria going to maximize her satisfaction on that grocery store trip? First she knows that she does not want to spend over $100. That means lots of choices about the combination of grocery items that she puts in her cart that will give her the most satisfaction and doesn't go over $100. She never studied economics and has no idea what utility is, but that is exactly what she is going to use to solve her puzzle!

Utility can be measured in two ways, one is called cardinal. It's based on the cardinal counting numbers like 1, 2, 3, 4. When Marie uses cardinal utility, she will subjectively place a value on the grocery items in the store by assigning a numerical value to them that represents the amount of satisfaction or happiness she will get when she eats it. Her numbers might look like this:

  • Roast beef slices 40 utils
  • Fish fillets 60 utils
  • Chicken breast 75 utils

She is going to choose the chicken because it will provide the most utility. She will also be willing to pay more for chicken than she would for fish or beef.

Ordinal Utility

Now it would be very unusual to find someone scribbling down measures of utility in a grocery store. It is far more likely that she would use the other measure of utility: ordinal.

Ordinal utility means ranking items under consideration from most satisfaction to the least. Many economists believe that consumers do this in their heads when they make purchase decisions. Once Marie has enough items in her cart to cover the main courses for her meals, it's time for the fun part, that's when she gets to buy the desserts and snacks!

She loves ice cream. She love fudge swirl the most, followed by chocolate, then strawberry. This will determine how much she is willing to pay for these flavors as such:

She will pay the most for the ones that give her the most utility!
flavor chart

Notice how there are no utils in the ordinal measure, just a ranking of her preferences in ice cream. She always goes for her favorite until she thinks another flavor would provide more utility. That happens sometimes when she has been eating too much fudge swirl!

Utility and Demand Curves

Now that we know the most Marie is willing to pay for the different flavors, we can use that info to begin to construct demand curves for them.

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