In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility represents the satisfaction that consumers receive for choosing and consuming a product or service.

Utility is measured in units called utils, but calculating the benefit or satisfaction that consumers receive from is abstract and difficult to pinpoint. As a result, economists measure utility in terms of revealed preferences by observing consumers' choices. From there, economists create an ordering of consumption baskets from least desired to the most preferred.

Understanding Utility Function

In economics, the utility function measures the welfare or satisfaction of a consumer as a function of consumption of real goods such as food or clothing. Utility function is widely used in the rational choice theory to analyze human behavior.

When economists measure the preferences of consumers, it's referred to ordinal utility. In other words, the order in which consumers choose one product over another can establish that consumers assign a higher value to the first product. Ordinal utility measures how consumers rank one product versus another.

Economists take the utility-function concept one step farther by assigning a numerical value to the products that consumers choose or choose not to consume. Assigning a value of utility is called cardinal utility, and the metric used to it is called utils.

For example, in certain situations, tea and coffee can be considered perfect substitutes for each other, and the appropriate utility function must reflect such preferences with a utility form of u(c, t) = c + t, where "u" denotes the utility function and "c" and "t" denote coffee and tea. Economists might conclude that a consumer who consumes one pound of coffee and no tea derives a utility of 1 util. 

Key Takeaways

  • In economics, utility function is an important concept that measures preferences over a set of goods and services.
  • Utility represents the satisfaction that consumers receive for choosing and consuming a product or service.
  • Economists track consumer choices to ascertain the utility of one product versus another and assign a numerical value to that utility.
  • Company executives research consumers' utility to guide the company's advertising, sales, and new product offerings.

Applying Utility Function

Let's say a consumer is shopping for a new car and has narrowed the choice down to two cars. The cars are nearly identical except that the second car has enhanced safety features and as a result, costs $2,000 more than the first car.

Economists might conclude that the consumer prefers the added safety features and thus, assigns a higher value to car two versus car one. The utility or satisfaction derived from car two could be represented numerically as the $2,000 price difference in the two cars. In other words, the consumer is receiving $2,000 in utility from car two.

Let's take say that 100,000 consumers throughout the economy preferred car two to car one. Economists can infer that consumers overall received $200,000,000 million worth of utility from the safety features of car two or (100,000 * $2,000 ). The utility is derived from the belief by consumers that they're likely to have fewer accidents by choosing the added safety features of car two.

Limitations and Benefits of Utility Function

Of course, in reality, economists can't assign a true numerical value to a consumer's level of satisfaction from a preference or choice. Also, pinpointing the reason for the purchase can be difficult if there are many variables being considered. In our simple example, the two cars were nearly identical. In reality, there might be several features or differences between the two cars. As a result, assigning a value to a consumer's preference can be challenging since one consumer might prefer the safety features while another might prefer something else.

However, tracking and assigning values to utility can still be useful to economists. Over time, choices and preferences can indicate changes in spending patterns and in utility. Understanding the logic behind consumer choices and the level of satisfaction is not only important to economists but companies as well. Company executives can use utility to track how consumers view their products. Also, the findings from studying consumers' utility can guide a company's advertising, sales, and new product offerings or upgrades.