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Utility Theory

Updated: Jan 25, 2021

More theories?? You bet.

What Does the Word Utility Mean?

The term “utility” when used to describe economics, refers to the amount of enjoyment or happiness that a person will receive from either a service or a good. In a broader context, it’s used to describe how someone can measure their best possible outcome.

Can We Calculate the "Most Bang For Our Buck?"

By dividing the marginal utility of good “x” by its price, and setting it equal to the marginal utility of good “y” divided by its price (MUx/px=MUy/py).

This formula is referred to as utility maximizing rule. On a graph, the utility curve is tangent to the budget constraint. To maximize happiness with the price that is being paid, the quantity of the higher number should increase while the quantity of the lower number should decrease.

Choosing Between Pizza and Hamburgers?

According to this table, pizza and hamburgers are the two goods being compared. The price per pound of pizza is $5 while hamburgers are $6 dollars. You received a marginal utility of 20 from the last pound of pizza and 30 from the last pound of hamburgers. You are then asked if you should buy more pizza and less hamburgers or vice versa.

According to the formula, you would plug in the numbers in marginal utility of pizza/price of pizza=marginal utility of hamburgers/price of hamburgers. If we plug in 20/4 (MU/P) for pizza, we receive a number of 4. If we plug in 30/6 (MU/P) for hamburgers, we get a number of 5. Because we increase the quantity of the higher number to maximize our utility, we should purchase more hamburgers instead of pizza and at the same time, decrease our consumption of pizza.

How Much Lasagna can Garfield Eat?

Garfield eating lasagna

We can also see utility visually. On the graph above comparing lasagna with utility, we clearly see the point of optimization. The point of optimization is located where Garfield is saying he doesn’t want to eat anymore because that is the peak of the curve. If he eats one more serving of lasagna, his happiness will decrease. Although his happiness is increasing, it’s important to know that it is increasing at a decreasing rate.

Take a look at how much the curve increases when he eats three to four servings of lasagna. He’s extremely happy as seen by his facial expression. In comparison, his happiness increases but barely when he eats one serving after his thirtieth one.

If Garfield eats one more serving, he’s not going to be very happy as demonstrated by his pleas and angry face. Therefore, the law of diminishing marginal utility states that in a given time period, the marginal utility from consumption of one more of “x” goods will fall. And this concept is responsible for the convexity of the curve.

So now you know why the first bite to any food is typically the best. As you eat more and more, you may feel happiness during the beginning and feel sluggish towards the end. You have the utility maximizing rule to thank for that.

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