Utility

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This article is about the economic concept. For other uses, see Utility
(disambiguation).

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Within economics, the concept of utility is used to model worth or value. Its usage
has evolved significantly over time. The term was introduced initially as a measure of
pleasure or satisfaction within the theory of utilitarianism by moral philosophers such
as Jeremy Bentham and John Stuart Mill. The term has been adapted and reapplied
within neoclassical economics, which dominates modern economic theory, as
a utility function that represents a consumer's preference ordering over a choice
set. It is devoid of its original interpretation as a measurement of the pleasure or
satisfaction obtained by the consumer from that choice.

Contents

 1Utility function
 2Applications
  3Revealed preference
 4Functions
o 4.1Cardinal
o 4.2Ordinal
o 4.3Preferences
o 4.4Revealed preferences in finance
o 4.5Examples
 5Expected utility
o 5.1von Neumann–Morgenstern
o 5.2As probability of success
 6Indirect utility
o 6.1Money
 7Discussion and criticism
 8See also
 9References
 10Further reading
 11External links

Utility function[edit]
Consider a set of alternatives facing an individual, and over which the individual has
a preference ordering. A utility function is able to represent those preferences if it is
possible to assign a real number to each alternative, in such a way that alternative
a is assigned a number greater than alternative b if, and only if, the individual
prefers alternative a to alternative b. In this situation an individual that selects the
most preferred alternative available is necessarily also selecting the alternative that
maximises the associated utility function. In general economic terms, a utility function
measures preferences concerning a set of goods and services. Often, utility is
correlated with words such as happiness, satisfaction, and welfare, and these are
hard to measure mathematically. Thus, economists utilize consumption baskets of
preferences in order to measure these abstract, non quantifiable ideas.
Gérard Debreu precisely defined the conditions required for a preference ordering to
be representable by a utility function.[1] For a finite set of alternatives these require
only that the preference ordering is complete (so the individual is able to determine
which of any two alternatives is preferred, or that they are equally preferred), and
that the preference order is transitive.

Applications[edit]
Utility is usually applied by economists in such constructs as the indifference curve,
which plot the combination of commodities that an individual or a society would
accept to maintain a given level of satisfaction. Utility and indifference curves are
used by economists to understand the underpinnings of demand curves, which are
half of the supply and demand analysis that is used to analyze the workings
of goods markets.
Individual utility and social utility can be construed as the value of a utility function
and a social welfare function respectively. When coupled with production or
commodity constraints, under some assumptions these functions can be used to
analyze Pareto efficiency, such as illustrated by Edgeworth boxes in contract curves.
Such efficiency is a central concept in welfare economics.
In finance, utility is applied to generate an individual's price for an asset called
the indifference price. Utility functions are also related to risk measures, with the
most common example being the entropic risk measure.
In the field of artificial intelligence, utility functions are used to convey the value of
various outcomes to intelligent agents. This allows the agents to plan actions with
the goal of maximizing the utility (or "value") of available choices.

Revealed preference[edit]
It was recognized that utility could not be measured or observed directly, so instead
economists devised a way to infer underlying relative utilities from observed choice.
These 'revealed preferences', as they were named by Paul Samuelson, were
revealed e.g. in people's willingness to pay:
Utility is taken to be correlative to Desire or Want. It has been already argued that
desires cannot be measured directly, but only indirectly, by the outward phenomena
to which they give rise: and that in those cases with which economics is chiefly
concerned the measure is found in the price which a person is willing to pay for the
fulfillment or satisfaction of his desire. [2]:78

Functions[edit]
There has been some controversy over the question whether the utility of
a commodity can be measured or not. At one time, it was assumed that the
consumer was able to say exactly how much utility he got from the commodity. The
economists who made this assumption belonged to the 'cardinalist school' of
economics. Today utility functions, expressing utility as a function of the amounts
of the various goods consumed, are treated as either cardinal or ordinal, depending
on whether they are or are not interpreted as providing more information than simply
the rank ordering of preferences over bundles of goods, such as information on the
strength of preferences.
Cardinal[edit]
Main article: Cardinal utility
When cardinal utility is used, the magnitude of utility differences is treated as an
ethically or behaviorally significant quantity. For example, suppose a cup of orange
juice 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. With cardinal utility, it can be concluded that the cup of
orange juice is better than the cup of tea by exactly the same amount by which the
cup of tea is better than the cup of water. Formally speaking, this means that if one
has a cup of tea, she would be willing to take any bet with a probability, p, greater
than .5 of getting a cup of juice, with a risk of getting a cup of water equal to 1-p. One
cannot conclude, however, that the cup of tea is two thirds of the goodness of the
cup of juice, because this conclusion would depend not only on magnitudes of utility
differences, but also on the "zero" of utility. For example, if the "zero" of utility was
located at -40, then a cup of orange juice would be 160 utils more than zero, a cup of
tea 120 utils more than zero. Cardinal utility, to economics, can be seen as the
assumption that utility can be measured through quantifiable characteristics, such as
height, weight, temperature, etc.
Neoclassical economics has largely retreated from using cardinal utility functions as
the basis of economic behavior. A notable exception is in the context of analyzing
choice under conditions of risk (see below).
Sometimes cardinal utility is used to aggregate utilities across persons, to create
a social welfare function.
Ordinal[edit]
Main article: Ordinal utility
When ordinal utilities are used, differences in utils (values taken on by the utility
function) are treated as ethically or behaviorally meaningless: the utility index
encodes a full behavioral ordering between members of a choice set, but tells
nothing about the related strength of preferences. In the above example, it would
only be possible to say that juice is preferred to tea to water, but no more. Thus,
ordinal utility utilizes comparisons, such as "preferred to", "no more", "less than", etc.
Ordinal utility functions are unique up to increasing monotone (or monotonic)
transformations. For example, if a function  is taken as ordinal, it is equivalent to the
function , because taking the 3rd power is an increasing monotone transformation (or
monotonic transformation). This means that the ordinal preference induced by these
functions is the same (although they are two different functions). In contrast, cardinal
utilities are unique only up to increasing linear transformations, so if  is taken as
cardinal, it is not equivalent to .
Preferences[edit]
Although preferences are the conventional foundation of microeconomics, it is often
convenient to represent preferences with a utility function and analyze human
behavior indirectly with utility functions. Let X be the consumption set, the set of all
mutually-exclusive baskets the consumer could conceivably consume. The
consumer's utility function  ranks each package in the consumption set. If the
consumer strictly prefers x to y or is indifferent between them, then .
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 micro-economic 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 , and each package  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  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  represents a preference relation  on X iff for every ,  implies . If u
represents , then this implies  is complete and transitive, and hence rational.
Revealed preferences in finance[edit]
In financial applications, e.g. portfolio optimization, an investor chooses financial
portfolio which maximizes his/her own utility function, or, equivalently, minimizes
his/her risk measure. For example, modern portfolio theory selects variance as a
measure of risk; other popular theories are expected utility theory,[3] and prospect
theory.[4] To determine specific utility function for any given investor, one could design
a questionnaire procedure with questions in the form: How much would you pay for x
% chance of getting y? Revealed preference theory suggests a more direct
approach: observe a portfolio X* which an investor currently holds, and then find a
utility function/risk measure such that X* becomes an optimal portfolio.[5]
Examples[edit]
In order to simplify calculations, various alternative assumptions have been made
concerning details of human preferences, and these imply various alternative utility
functions such as:

 CES (constant elasticity of substitution, or isoelastic)

utility
 Isoelastic utility
 Exponential utility
 Quasilinear utility
 Homothetic preferences
 Stone–Geary utility function
 Gorman polar form
o Greenwood–Hercowitz–Huffman preferences
o King–Plosser–Rebelo preferences
 Hyperbolic absolute risk aversion
Most utility functions used in modeling or theory are well-behaved. They are usually
monotonic and quasi-concave. However, it is possible for preferences not to be
representable by a utility function. An example is lexicographic preferences which
are not continuous and cannot be represented by a continuous utility function. [6]

Expected utility[edit]
Main article: Expected utility hypothesis
The expected utility theory deals with the analysis of choices among risky projects
with multiple (possibly multidimensional) outcomes.
The St. Petersburg paradox was first proposed by Nicholas Bernoulli in 1713 and
solved by Daniel Bernoulli in 1738. D. Bernoulli argued that the paradox could be
resolved if decision-makers displayed risk aversion and argued for a logarithmic
cardinal utility function. (Analyses of international survey data in the 21st century
have shown that insofar as utility represents happiness, as in utilitarianism, it is
indeed proportional to log income.)
The first important use of the expected utility theory was that of John von
Neumann and Oskar Morgenstern, who used the assumption of expected utility
maximization in their formulation of game theory.
von Neumann–Morgenstern[edit]
Main article: Von Neumann–Morgenstern utility theorem
Von Neumann and Morgenstern addressed situations in which the outcomes of
choices are not known with certainty, but have probabilities attached to them.
A notation for a lottery is as follows: if options A and B have probability p and 1 − p in
the lottery, we write it as a linear combination:
More generally, for a lottery with many possible options:
where .
By making some reasonable assumptions about the
way choices behave, von Neumann and
Morgenstern showed that if an agent can choose
between the lotteries, then this agent has a utility
function such that the desirability of an arbitrary
lottery can be calculated as a linear combination of
the utilities of its parts, with the weights being their
probabilities of occurring.
This is called the expected utility theorem. The
required assumptions are four axioms about the
properties of the agent's preference relation over
'simple lotteries', which are lotteries with just two
options. Writing  to mean 'A is weakly preferred to B'
('A is preferred at least as much as B'), the axioms
are:
1. completeness: For any two simple
lotteries  and , either  or  (or both, in which
case they are viewed as equally desirable).
2. transitivity: for any three lotteries , if  and ,
then .
3. convexity/continuity (Archimedean property):
If , then there is a  between 0 and 1 such that
the lottery  is equally desirable as .
4. independence: for any three lotteries  and
any probability p,  if and only if . Intuitively, if
the lottery formed by the probabilistic
combination of  and  is no more preferable
than the lottery formed by the same
probabilistic combination of  and  then and
only then .
Axioms 3 and 4 enable us to decide about the
relative utilities of two assets or lotteries.
In more formal language: A von Neumann–
Morgenstern utility function is a function from
choices to the real numbers:
which assigns a real number to every outcome in
a way that captures the agent's preferences over
simple lotteries. Under the four assumptions
mentioned above, the agent will prefer a
 lottery  to a lottery  if and only if, for the utility
function characterizing that agent, the expected
utility of  is greater than the expected utility of :
.
Of all the axioms, independence is the most
often discarded. A variety of generalized
expected utility theories have arisen, most of
which drop or relax the independence axiom.
As probability of success[edit]
Castagnoli and LiCalzi (1996) and Bordley
and LiCalzi (2000) provided another
interpretation for Von Neumann and
Morgenstern's theory. Specifically for any
utility function, there exists a hypothetical
reference lottery with the expected utility of
an arbitrary lottery being its probability of
performing no worse than the reference
lottery. Suppose success is defined as
getting an outcome no worse than the
outcome of the reference lottery. Then this
mathematical equivalence means that
maximizing expected utility is equivalent to
maximizing the probability of success. In
many contexts, this makes the concept of
utility easier to justify and to apply. For
example, a firm's utility might be the
probability of meeting uncertain future
customer expectations.[7][8][9][10]

Indirect utility[edit]
Main article: Indirect utility
An indirect utility function gives the optimal
attainable value of a given utility function,
which depends on the prices of the goods
and the income or wealth level that the
individual possesses.
Money[edit]
One use of the indirect utility concept is the
notion of the utility of money. The (indirect)
utility function for money is a nonlinear
function that is bounded and asymmetric
about the origin. The utility function
is concave in the positive region, reflecting
the phenomenon of diminishing marginal
utility. The boundedness reflects the fact that
beyond a certain point money ceases being
useful at all, as the size of any economy at
any point in time is itself bounded. The
asymmetry about the origin reflects the fact
that gaining and losing money can have
radically different implications both for
individuals and businesses. The non-linearity
of the utility function for money has profound
implications in decision making processes: in
situations where outcomes of choices
influence utility through gains or losses of
money, which are the norm in most business
settings, the optimal choice for a given
decision depends on the possible outcomes
of all other decisions in the same time-period.
[11]

Discussion and criticism[edit]

Cambridge economist Joan
Robinson famously criticized utility for being
a circular concept: "Utility is the quality in
commodities that makes individuals want to
buy them, and the fact that individuals want
to buy commodities shows that they have
utility."[12]:48 Robinson also pointed out that
because the theory assumes that
preferences are fixed this means that utility is
not a testable assumption. This is so
because if we take changes in peoples'
behavior in relation to a change in prices or a
change in the underlying budget constraint
we can never be sure to what extent the
change in behavior was due to the change in
price or budget constraint and how much was
due to a change in preferences.[13] This
criticism is similar to that of the
philosopher Hans Albert who argued that the
ceteris paribus conditions on which the
marginalist theory of demand rested
rendered the theory itself an empty tautology
and completely closed to experimental
testing.[14] In essence, demand and supply
curve (theoretical line of quantity of a product
which would have been offered or requested
for given price) is purely ontological and
could never been demonstrated empirically.
Another criticism comes from the assertion
that neither cardinal nor ordinal utility is
empirically observable in the real world. In
the case of cardinal utility it is impossible to
 measure the level of satisfaction
"quantitatively" when someone consumes or
purchases an apple. In case of ordinal utility,
it is impossible to determine what choices
were made when someone purchases, for
example, an orange. Any act would involve
preference over a vast set of choices (such
as apple, orange juice, other vegetable,
vitamin C tablets, exercise, not purchasing,
etc.).[15][16]
Other questions of what arguments ought to
enter into a utility function are difficult to
answer, yet seem necessary to
understanding utility. Whether people gain
utility from coherence of wants, beliefs or a
sense of duty is key to understanding their
behavior in the utility organon.[17] Likewise,
choosing between alternatives is itself a
process of determining what to consider as
alternatives, a question of choice within
uncertainty.[18]
An evolutionary psychology perspective is
that utility may be better viewed as due to
preferences that maximized
evolutionary fitness in the ancestral
environment but not necessarily in the
current one.[19]

See also[edit]

 Business and Economics portal

 Law of demand
 Marginal utility
 Utility maximization problem
 Decision-making software

References[edit]
1. ^ Debreu, Gérard (1954), "Representation of a
preference ordering by a numerical function", in
Thrall, Robert M.;  Coombs, Clyde H.;  Raiffa,
Howard (eds.), Decision processes, New York:
Wiley, pp.  159–167,  OCLC 639321.
2. ^ Marshall, Alfred (1920). Principles of
Economics. An introductory volume  (8th ed.).
London: Macmillan.
3. ^ Von Neumann, J.; Morgenstern, O.
(1953).  Theory of Games and Economic
Behavior(3rd ed.). Princeton University Press.
4. ^ Kahneman, D.;  Tversky, A. (1979).  "Prospect
Theory: An Analysis of Decision Under
Risk"  (PDF). Econometrica. 47 (2): 263–
292.  doi:10.2307/1914185.  JSTOR  1914185.
5. ^ Grechuk, B.; Zabarankin, M. (2016). "Inverse
Portfolio Problem with Coherent Risk
Measures". European Journal of Operational
Research.  249  (2): 740–
750.  doi:10.1016/j.ejor.2015.09.050.  hdl:2381/3
6136.
6. ^ Ingersoll, Jonathan E., Jr. (1987).  Theory of
Financial Decision Making. Totowa: Rowman
and Littlefield. p.  21. ISBN 0-8476-7359-6.
7. ^ Castagnoli, E.; LiCalzi, M. (1996).  "Expected
Utility Without Utility"  (PDF).  Theory and
Decision. 41 (3): 281–
301.  doi:10.1007/BF00136129. hdl:10278/4143.
8. ^ Bordley, R.; LiCalzi, M. (2000). "Decision
Analysis Using Targets Instead of Utility
Functions".  Decisions in Economics and
Finance. 23 (1): 53–
74.  doi:10.1007/s102030050005.  hdl:10278/36
10.
9. ^ Bordley, R.; Kirkwood, C. (2004).
"Multiattribute preference analysis with
Performance Targets". Operations
Research.  52  (6): 823–
835.  doi:10.1287/opre.1030.0093.
10. ^ Bordley, R.; Pollock, S. (2009).  "A Decision-
Analytic Approach to Reliability-Based Design
Optimization". Operations Research.  57  (5):
1262–1270.  doi:10.1287/opre.1080.0661.
11. ^ Berger, J. O. (1985). "Utility and
Loss".  Statistical Decision Theory and Bayesian
Analysis(2nd ed.). Berlin: Springer-
Verlag.  ISBN  3-540-96098-8.
12. ^ Robinson, Joan (1962). Economic
Philosophy. Harmondsworth, Middle-sex, UK:
Penguin Books.
13. ^ Pilkington, Philip (17 February 2014).  "Joan
Robinson's Critique of Marginal Utility
Theory".  Fixing the Economists.  Archived  from
the original on 13 July 2015.
14. ^ Pilkington, Philip (27 February 2014).  "utility
Hans Albert Expands Robinson's Critique of
Marginal Utility Theory to the Law of
Demand". Fixing the
Economists. Archived from the original on 19
July 2015.
15. ^ "Revealed Preference Theory". Archived
from  the original on 16 July 2011. Retrieved 11
December 2009.
16. ^ "Archived copy"  (PDF). Archived from the
original  (PDF)  on 15 October 2008. Retrieved  9
August  2008.
 17. ^ Klein, Daniel (May
2014). "Professor"  (PDF).  Econ Journal
Watch. 11 (2): 97–105. Archived  (PDF)  from
the original on 5 October 2014. Retrieved 15
November 2014.
18. ^ Burke, Kenneth (1932). Towards a Better Life.
Berkeley, Calif: University of California Press.
19. ^ Capra, C. Monica; Rubin, Paul H. (2011).
"The Evolutionary Psychology of
Economics".  Applied Evolutionary Psychology.
Oxford University
Press. doi:10.1093/acprof:oso/9780199586073.
003.0002.  ISBN  9780191731358.

Further reading[edit]
 Anand, Paul (1993). Foundations of
Rational Choice Under Risk. Oxford:
Oxford University Press. ISBN 0-19-
823303-5.
 Fishburn, Peter C. (1970). Utility Theory
for Decision Making. Huntington, NY:
Robert E. Krieger. ISBN 0-88275-736-9.
 Georgescu-Roegen, Nicholas (August
1936). "The Pure Theory of Consumer's
Behavior". Quarterly Journal of
Economics. 50 (4): 545–
593. doi:10.2307/1891094. JSTOR 1891
094.
 Gilboa, Itzhak (2009). Theory of Decision
under Uncertainty. Cambridge:
Cambridge University Press. ISBN 978-
0-521-74123-1.
 Kreps, David M. (1988). Notes on the
Theory of Choice. Boulder, CO: West-
view Press. ISBN 0-8133-7553-3.
 Nash, John F. (1950). "The Bargaining
Problem". Econometrica. 18 (2): 155–
162. doi:10.2307/1907266. JSTOR 1907
266.
 Neumann, John von & Morgenstern,
Oskar (1944). Theory of Games and
Economic Behavior. Princeton, NJ:
Princeton University Press.
 Nicholson, Walter (1978). Micro-
economic Theory (Second ed.). Hinsdale:
Dryden Press. pp. 53–87. ISBN 0-03-
020831-9.
  Plous, S. (1993). The Psychology of
Judgement and Decision Making. New
York: McGraw-Hill. ISBN 0-07-050477-6.

External links[edit]
Wikimedia Commons has
media related to Utility
(decision theory).

 Definition of Utility by Investopedia

 Anatomy of Cobb-Douglas Type Utility
Functions in 3D
 Anatomy of CES Type Utility Functions in
3D
 Simpler Definition with example from
Investopedia
 Maximization of Originality - redefinition of
classic utility
 Utility Model
of Marketing - Form, Place, Time, Posses
sion and perhaps also Task
show

Commodities and commoditization

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Microeconomics

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