UTILITY ANALYSIS

A subset of consumer demand theory that analysis consumer behavior

and market demand using total utility and marginal utility. The key
principle of utility analysis is the law of diminishing marginal utility,
which offers an explanation for the law of demand and the negative
slope of the demand curve.
Utility analysis, a subset of consumer demand theory, provides insight
into an understanding of market demand and forms a cornerstone of
modern microeconomics. In particular, this analysis investigates
consumer behavior, especially market purchases, is based on the
satisfaction of wants and needs (that is, utility) generated from the
consumption of a good.
Utility analysis is primarily taught in introductory courses. A more
sophisticated version of consumer demand theory relies on the analysis
of indifference curves and is more commonly found at the intermediate
course level and above.
Utility and Satisfaction
The primary focus of utility analysis is on the satisfaction of wants and
needs obtained by the consumption of goods. This is technically termed
utility. The utility generated from consumption affects the decision to
purchase and consume a good. When used in the analysis of consumer
behavior, utility assumes a very precise meaning, which differs from the
everyday use of the term.In common use, the term utility means
"useful."
For example, a "utility" knife is one with many uses, something that is
handy to have around. In baseball, a "utility" player can perform quite
well at several different positions and is thus useful to have on the team.
Moreover, a public "utility" is a company that supplies a useful product,
such as electricity, natural gas, or trash collection.
In contrast, the specific economic use of the term utility in the study of
consumer behavior means the satisfaction of wants and needs obtained
from the consumption of a commodity. The good consumed need not be
"useful" in the everyday sense of the term. It only needs to provide
satisfaction.
The Law of Demand
The primary focus of utility analysis is an understanding of market
demand and the law of demand. The law of demand, which gives rise to
a negatively-sloped demand curve, is an essential principle underlying
market analysis. Modern microeconomic theory, among other topics, is
concerned with understanding and explaining the law of demand. The
explanation of the law of demand using utility analysis is relatively
simple. Consumers purchase goods that satisfy wants and needs, that is,
generate utility. Those goods that generate more utility are more
valuable to consumers and thus buyers are willing to pay a higher price.
The key to the law of demand is that the utility generated declines as the
quantity consumed increases. As such, the demand price that buyers are
willing to pay decreases as the quantity demanded increases.
Total Utility
Utility analysis begins with the total utility derived from the
consumption of different quantities of a good. Total utility is simply a
measure of the total satisfaction of wants and needs obtained from the
consumption or use of a good or service. It is often convenient to present
total utility for a range of quantities in a table such as the one displayed
to the right.
 Utility analysis is based on the presumption that the Total Utility
amount of utility generated from the consumption of a good can be
explicitly measured. The standard hypothetical measurement unit is
"utils." Suppose, for example, that Edgar Millbottom spends a day riding
the Monster Loop Death Plunge roller coaster at the Shady Valley
Amusement Park, then records the amount of total utility achieved at the
end of each ride.
Rides Total Utility (util)
0 0
1 11
2 20
3 27
4 32
5 35
6 36
.

What Is Marginal Utility?

Marginal utility is the added satisfaction that a consumer gets from

having one more unit of a good or service. The concept of marginal
utility is used by economists to determine how much of an item
consumers are willing to purchase.

Positive marginal utility occurs when the consumption of an additional

item increases the total utility. On the other hand, negative marginal
utility occurs when the consumption of one more unit decreases the
overall utility.

 Marginal utility is the added satisfaction a consumer gets from

having one more unit of a good or service.
 The concept of marginal utility is used by economists to determine
how much of an item consumers are willing to purchase.
  The law of diminishing marginal utility is often used to justify
progressive taxes.
 Marginal utility can be positive, zero, or negative.

Types of Marginal Utility

There are multiple kinds of marginal utility. Three of the most common
ones are as follows:

Positive Marginal Utility

Positive marginal utility occurs when having more of an item brings
additional happiness. Suppose you like eating a slice of cake, but a
second slice would bring you some extra joy. Then, your marginal
utility from consuming cake is positive.

Zero Marginal Utility

Zero marginal utility is what happens when consuming more of an
item brings no extra measure of satisfaction. For example, you might
feel fairly full after two slices of cake and wouldn't really feel any better
after having a third slice. In this case, your marginal utility from eating
cake is zero.

Negative Marginal Utility

Negative marginal utility is where you have too much of an item, so
consuming more is actually harmful. For instance, the fourth slice of
cake might even make you sick after eating three pieces of cake.

Cardinal and Ordinal Utility

Summary: Cardinal utility gives a value of utility to different options.
Ordinal utility just ranks in terms of preference.

Cardinal Utility is the idea that economic welfare can be directly

observable and be given a value.
For example, people may be able to express the utility that consumption
gives for certain goods. For example, if a Nissan car gives 5,000 units of
utility, a BMW car would give 8,000 units. This is important for welfare
economics which tries to put values on consumption. For example,
allocative efficiency is said to occur when Marginal cost = Marginal
Utility.

One way to try and put values on goods utility is to see what price they
are willing to pay for a good.

If we are willing to pay £5,000 for a second-hand Nissan Car, we can

infer we must get 5,000 utils. In other words, the value of cardinal utility
is related to the price we are willing to pay.

The idea of cardinal utility is important to rational choice theory. The

idea consumers make optimal choices to maximise their utility.

Ordinal Utility
In ordinal utility, the consumer only ranks choices in terms of preference
but we do not give exact numerical figures for utility.

For example, we prefer a BMW car to a Nissan car, but we don’t say by
how much.

It is argued this is more relevant in the real world. When deciding where
to go for lunch, we may just decide I prefer an Italian restaurant to
Chinese. We don’t calculate the exact levels of utility.