Utility Theory
| Author | Michael Doumpos, Constantin Zopounidis |
| Pages | 944-945 |
Page 944
Utility theory provides a methodological framework for the evaluation of alternative choices made by individuals, firms and organizations. Utility refers to the satisfaction that each choice provides to the decision maker. Thus, utility theory assumes that any decision is made on the basis of the utility maximization principle, according to which the best choice is the one that provides the highest utility (satisfaction) to the decision maker.
Utility theory is often used to explain the behavior of individual consumers. In this case the consumer plays the role of the decision maker that must decide how much of each of the many different goods and services to consume so as to secure the highest possible level of total utility subject to his/her available income and the prices of the goods/services.
In addition to providing an explanation of consumer disposition of income, utility theory is useful in establishing individual consumer demand curves for goods and services. A consumer's demand curve for a good or service shows the different quantities that consumers purchase at various alternative prices. Factors that are held constant are consumers' tastes and preferences, income, and price.
In all cases the utility that the decision maker gets from selecting a specific choice is measure by a utility function U, which is a mathematical representation of the decision maker's system of preferences such that: U(x) > U(y), where choice x is preferred over choice y or U(x) = U(y), where choice x is indifferent from choice y—both choices are equally preferred.
Utility functions can be either cardinal or ordinal. In the former case, a utility function is used to derive a numerical score for each choice that represents the utility of this choice. In this setting the utilities (scores) assigned to different choices are directly comparable. For instance, a utility of 100 units towards a cup of tea is twice as desirable as a cup of coffee with a utility level of 50 units. In the ordinal case, the magnitude of the utilities (scores) are not important; only the ordering of the choices as implied by their utilities matters. For instance, a utility...
To continue reading
Request your trial