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Utility

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For other uses, see Utility (disambiguation).

In economics, utility is a measure of the happiness or satisfaction gained consuming good and services. Given this measure, one may speak meaningfully of increasing or decreasing utility, and thereby explain economic behavior in terms of rational attempts to increase one's utility. In neoclassical economics, rationality is precisely defined in terms of utility-maximizing behavior, under economic constraints.

The concept is applied by economists in such topics as the indifference curve, which plots the combination of commodities that an individual or a community requires to maintain a given level of satisfaction. The concept is also used in utility functions, social welfare functions, Pareto maximization, Edgeworth boxes and contract curves. It is a central concept of welfare economics.

The doctrine of utilitarianism saw the maximisation of utility as a moral criterion for the organisation of society. According to utilitarians, such as Jeremy Bentham (1748-1832) and John Stuart Mill (1806-1876), society should aim to maximise the total utility of individuals, aiming for "the greatest happiness for the greatest number."

1 Cardinal and ordinal utility
2 Utility functions
3 Expected utility
4 Discussion and criticism
5 See also
6 References and additional reading

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Cardinal and ordinal utility

Economists distinguish between cardinal utility and ordinal utility. When cardinal utility is used, the magnitude of utility differences is a meaningful quantity. On the other hand, ordinal utility captures only ranking and not strength of preferences.

Utility functions of both sorts assign real numbers (utils) to members of a choice set. For example, suppose a cup of coffee has utility of 120 utils, a cup of tea has a utility of 80 utils, and a cup of water has a utility of 40 utils. When speaking of cardinal utility, it could be concluded that the cup of coffee is exactly the same amount better as a cup of tea as the cup of tea is better than the cup of water.

It is tempting when dealing with cardinal utility to aggregate utilities across persons. This should be avoided: interpersonal comparisons of utility are suspect because there is no good way to interpret how different people value consumption bundles.

When ordinal utilities are used, differences in utils are not meaningful. The utility values assigned encode an full ordering between members of a choice set, but nothing about strength of preferences. In the above example, it would only be possible to say that coffee is preferred to tea to water, but no more.

Neoclassical economics has largely retreated from using utility functions as the basic objects of economic analysis, in favour of considering agent preferences over choice sets. As will be seen in subsequent sections, however, preference relations can often be rationalized as utility functions satisfying a variety of useful properties.

Utility functions are not unique. Ordinal utility functions are equivalent up to monotone transformations, while cardinal utilities are equivalent up to positive linear transformations.

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Utility functions

While preferences are the conventional foundation of microeconomics, it is convenient to represent preferences with a utility function and reason indirectly about preferences with utility functions. Let X be the consumption set, the set of all packages the consumer could conceivably consume. The consumer's utility function $u : X \rightarrow \textbf R$ assigns a happiness score to each package in the consumption set. If u(x) > u(y), then the consumer strictly prefers x to y.

For example, suppose a consumer's consumption set is X = {nothing, 1 apple, 1 orange, 1 apple and 1 orange, 2 apples, 2 oranges}, and its utility function is u(nothing) = 0, u(1 apple) = 1, u(1 orange) = 2, u(1 apple and 1 orange) = 4, u(2 apples) = 2 and u(2 oranges) = 3. Then this consumer prefers 1 orange to 1 apple, but prefers one of each to 2 oranges.

In microeconomics models, there are usually a finite set of L commodities, and a consumer may consume an arbitrary amount of each commodity. This gives a consumption set of $\textbf R^L_+$ , and each package $x \in \textbf R^L_+$ is a vector containing the amounts of each commodity. In the previous example, we might say there are two commodities: apples and oranges. If we say apples is the first commodity, and oranges the second, then the consumption set X = $\textbf R^2_+$ and u(0, 0) = 0, u(1, 0) = 1, u(0, 1) = 2, u(1, 1) = 4, u(2, 0) = 2, u(0, 2) = 3 as before. Note that for u to be a utility function on X, it must be defined for every package in X.

A utility function $u : X \rightarrow \textbf{R}$ rationalizes a preference relation <= on X if for every $x, y \in X$ , u(x) <= u(y) if and only if x <= y. If u rationalizes <=, then this implies <= is complete and transitive, and hence rational.

In order to simplify calculations, various assumptions have been made of utility functions.

CES (constant elasticity of substitution) utility is one with constant relative risk aversion
quasilinear utility
homothetic utility

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Expected utility

The expected utility model was first proposed by Daniel Bernoulli as a solution to the St. Petersburg paradox. Bernoulli argued that the paradox could be resolved if decisionmakers displayed risk aversion and argued for a logarithmic cardinal utility function.

The first important use of the expected theory was that of John von Neumann and Oskar Morgenstern who used the assumption of expected utility maximization in their formulation of game theory.

A von Neumann-Morgenstern utility function $u : X \rightarrow \textbf{R}$ assigns a real number to every element of the outcome space in a way that captures the agent's preferences over both simple and compound lotteries (put in category-theoretic language, $u$ induces a morphism between the category of preferences under uncertainty and the category of reals). The agent will prefer a lottery $L 1$ to a lottery $L 2$ if and only if the expected utility (iterated over compound lotteries if necessary) of $L 1$ is greater than the expected utility of $L 2$ .

Restricting to the discrete choice context, let $L : X \rightarrow [0,1]$ be a simple lottery such that $L (x i) = p i$ , where $p i$ is the probability that $x i$ is won. We may also consider compound lotteries, where the prizes are themselves simple lotteries.

The expected utility theorem says that a von Neumann-Morgenstern utility function exists if and only if the agent's preference relation on the space of simple lotteries satisfies four axioms: completeness, transitivity, convexity/continuity (also called the Archimedean property), and independence.

Completeness and transitivity are discussed supra. The Archimedean property says that for simple lotteries $L_1 \geq L_2 \geq L_3$ , then there exists a $0 \leq p \leq 1$ such that the agent is indifferent between $L 2$ and the compound lottery mixing between $L 1$ and $L 3$ with probability $p$ and $1 - p$ , respectively. Independence means that if the agent is indifferent between simple lotteries $L 1$ and $L 2$ , the agent is also indifferent between $L 1$ mixed with an arbitrary simple lottery $L 3$ with probability $p$ and $L 2$ mixed with $L 3$ with the same probability $p$ .

Independence is probably the most controversial of the axioms. A variety of generalized expected utility theories have arisen, most of which drop or relax the independence axiom.

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Discussion and criticism

Different value systems have different perspectives on the use of utility in making moral judgments. For example, Marxists, Kantians, and certain libertarians (such as Nozick) all believe utility to be irrelevant as a moral standard or at least not as important as others such as natural rights. Meanwhile, conceptions such as natural rights and whether or not their goal-bearing representations are utility is plausibly debatable.

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References and additional reading

Neumann, John von and Morgenstern, Oskar Theory of Games and Economic Behavior. Princeton, NJ. Princeton University Press. 1944 sec.ed. 1947
Nash Jr., John F. The Bargaining Problem. Econometrica 18:155 1950

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Categories: Utility | Economics of uncertainty