Although the theory of consumer choice does not require us to assign a numerical value to the level of satisfaction that a consumer receives from consuming a good or service, it is useful to attach a number to this satisfaction level that we call utility.
Therefore, a definition for the concept of utility is the numerical value attached to the satisfaction that a consumer receives from consuming a given market basket.
For example, if buying 3 scoops of ice cream makes you happier than buying one shirt, then we say that the ice-cream gives you more utility than the shirt.
In other words, utility is a device used to simplify the ranking in terms of preference of market baskets.
Utility Function is represented by a formula that assigns a certain level of utility (satisfaction) to individual market baskets.
If the utility function is
U(F,C) = F + 2C
The above equation which is a particular example of an utility function can be interpreted as the level of satisfaction obtained from consuming F units of food and C units of clothing. Lets plug in some values and solve it:
A market basket with 8 units of food and 3 units of clothing gives a utility of:
14 = 8 + 2 x 3
Ranking Market Baskets
Although we assign numbers to utility and market baskets, this is only a convention which helps ranking different baskets of goods. One should not conclude that a utility of 4 is always and in any circumstance twice as good as a utility of 2.
There are two types of rankings for market baskets:
- Ordinal ranking
- Cardinal ranking
The Ordinal Utility Function places market baskets in the order of most preferred to least preferred, but it does not indicate by how much one market basket is preferred to another.
Cardinal Utility Function:
The Cardinal Utility Function shows to which extent one market basket is preferred to another. However, the actual unit of measure for utility is not important. Additionally, we have no way of telling whether a person gets twice as much satisfaction from one market basket than from another.
Therefore, an ordinal ranking is usually sufficient to explain how most of individual decisions are made. Furthermore, in economics the simple fact of attaching a number to the utility a consumer receives from buying a product is considered sufficient to understand consumer demand.