Microeconomics: Assumptions and Utility
by Marc Davis
The decision-making process of the individual consumer is critically important in the study of microeconomics because consumer spending accounts for about 70% of the economy.
Consumers also save money, invest it, stash it away for the future in banks, stocks, bonds, money market or mutual funds, or other forms of savings. Microeconomics also studies the decision-making processes that determine how much a household may save, where it is saved, for how long and why.
But because consumer spending is the engine that drives the economy, businesses continually pursue knowledge of how the consumer decision-making process works to better serve their markets with the most desired of products and services at usually, but not always, competitive prices.
A basic assumption of microeconomics is that because a consumer does not have an unlimited budget, his or her available cash for spending must be judiciously allocated for maximum benefit. Microeconomics also supposes that individual consumers make their buying decisions in an effort to obtain the most happiness at the least cost - in other words, maximizing happiness or benefit.
Happiness, of course, cannot be quantified. But there are methods and assumptions in the microeconomics tool box for calculating a reasonable approximation of this elusive concept. In microeconomics, happiness is measured by a concept called utility. The standard unit of measurement that microeconomics uses to measure utility is called the util. (To learn more, read Economics Basics: Utility.)
Utils and Utility
The util has no concrete numerical value like an inch or a centimeter. It is merely an arbitrary, subjective and convenient way to assign value to consumer choices and to measure the consumer utility or utils of one choice against another choice.
As an example, a consumer may go to the supermarket with $100 to spend, along with a phantom 100 utils representing 100% of the happiness the consumer expects to garner from all the purchases he makes. Two-thirds of that dollar amount is spent on necessities - meat, bread, milk, produce and other food staples. Although 67% of the money budgeted for purchases is spent on food stuffs, the number of utils assigned to those purchases - arbitrarily and subjectively - may only be 40. The remaining one-third of the money is spent on chocolate bars, ice cream, frozen pizza, soda pop and other unnecessary goodies. But the utils assigned to these purchases total 60.
So a rough numerical measure of consumer satisfaction is derived - what microeconomics calls cardinal utility, which refers to the cardinal numbers, starting with 1, 2, 3 and so on.There's a problem, however, with this concept, convenient though it may be: consumers don't as a rule calculate the numerical utility value of their purchases; only microeconomists do.
Ordinal utility, another term widely used in microeconomics, may be a more useful way of determining consumer satisfaction because it simply denotes consumer preferences without assigning them numerical values.
A consumer, for example, may prefer hot dogs to hamburgers; or he may purchase a coat at Target (NYSE:TGT) rather than Wal-Mart (NYSE:WMT). These are consumer preferences - their rankings of one product or brand against another. These preferences may be influenced by pricing, quality, convenience and other measurable factors along with the subjective, which is unquantifiable.
Why are such arbitrary and seemingly inexact measurements used in microeconomics? They provide at least some insight into the complexities of consumer decision-making. Both the numerical data - cardinal utility and the preferences data, ordinal utility - are extremely useful to businesses. Using this information, businesses can decide how much of a product or service to offer in the marketplace, and determine their optimum price for maximum sales.
Another term for consumer utility - cardinal utility, in this case - is consumer benefit. In any situation where a consumer buys more than one item of a product, the utility value may start to diminish as the consumer purchases or consumes more the product.
For instance, a single ice cream cone at a certain price may have a 75% utility value for the consumer. A consumer with two children who also want ice cream cones may assign a utility value of 100%, if price discounts are given for the purchase of additional ice cream cones.
Additional ice cream cones at additional price reductions, however, would have a declining utility value. Why? It is because there are only three consumers of the theoretical ice cream cones. Furthermore, the consumer is disinclined to buy the additional ice cream cones at a discounted price because by the time he or she gets them home, they'll have melted away. Further, the consumer does not want his or her children to consume more than one cone a day. Therefore, the utility value goes up along a certain trajectory that can be plotted on a chart, and declines along a descending trajectory at a certain point on the chart. The term for this decline is diminishing marginal utility.
In their quest for happiness - or utility - resulting from their purchases, consumers choose what to buy from a huge array of products and services offered in the marketplace, based on a variety of factors which contribute to their perception of utility.
Economists have pointed out a major flaw in the utility theory, however, which somewhat compromises its validity: Consumers do not always, or consistently, act in a logical, rational manner. Other elements may influence their decision-making, some of which they may be aware of, and others of that may be subconscious.
Nobel Memorial Prize winner in economics, Herbert A. Simon, postulated his theory of "satisficing" to address this apparent flaw.
Let's say that a consumer wants to buy a used car. Utility theory holds that consumers would evaluate an indeterminate number of used cars, calculate the value of their variables and then buy the car with the highest number derived from that formula. Simon's satisficing theory suggests that consumers may just evaluate a limited number of used cars in a used car lot conveniently nearby. The consumer then makes a buying choice he or she considers "good enough." This theory seems reasonable, and eliminates some of the flaws inherent in the utility theory.
Still, the utility theory remains a mainstay of the broader microeconomic theory, although economists continue to adjust it, propose new aspects of it, and tweak it in different subtle directions so that it encompasses all contingencies and variables in the phenomenon of consumer decision-making.
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