Utility

From Hobson's Choice

A fundamental concept in economics, particularly Neoclassical economics. Utility refers to the total scope of usefulness, pleasure, anticipation, aesthetic satisfaction, productive potential, or welfare enhancement of a thing. Economists tend to regard utility as an abstract concept that can be detached from the thing itself, so that, for example, a piano contains utility in so far as it is useful for recreation, visual beauty, social status, and the generation of music; this utility, as a concept on its own, is identical to the utility afforded by an elevator, an orange, or a gram of enriched uranium.

1 Some Further Details
2 The Utility Function
3 See Also
4 External Links

[edit]

Some Further Details

Utility is an abstract concept that (conceptually) allows the addition of heterogeneous bundles of goods, such as everything a consumer buys with her annual income. It is actually limited in scope by things the consumer actually consumes, however; yet economists understand that the consumer gets certain advantages by saving also. Consumers are assumed to discount their future utility relative to present utility, which results in the need for an offsetting rate of interest. However, consumers naturally do not spend all their income since they theoretically wish to maintain a constant rate of consumption (See constant relative risk aversion).

[edit]

The Utility Function

Click for larger image

In economics, one speaks of "utility" as a state that cannot be measured, but can be compared; so, for example, in the chart below, the blue line (U1) represents a lower lever level of utility than the red (U2). It is not valid to say U2 represents 1.5x as much utility, but we can include a very large number of intermediate levels of utility between the two points.

Utility is always described as a function of two sources, such as "wages" and "leisure" (from the POV of the worker). Of course, if you increase wages without reducing leisure, or increase both, then the person obviously has a higher level of utility. But what about when one must trade one for the other?

In the graph above, the economic actor's utility is a function of A and B. The red line is the result of a sudden decline in the price of B. When that happened, the "budget line"—the straight dashed lines slicing diagonally across the graph—moved outward, to the right. That diagonal line intersects the A-axis at the point where the consumer spends 100% of her income on A, and the B-axis where she spends 100% of her income on B. So when the price of B fell, the budget line moved outward to intersect with a new, higher, level of utility.

When the consumer had the lower (blue) budget line, she consumed A1 and B1. When the price of B fell, her consumption of both increased, to A2 and B2. But economists make a distinction between (A2, B2) and (A1.5, B1.5). While some of the change in consumption (ΔA,ΔB) can be explained by the increased income—i.e., the new, "purple" flashpoint on the red curve above—some of (ΔA,ΔB) is the result of substitution. So, for example, the increased real income caused by a decline in the price of B actually caused the consumption of A to decline in absolute terms. An income effect will always cause both to increase, but a substitution effect will always cause consumption of one to fall relative to the other.