UTILITY THEORY

CHOICE AND UTILITY THEORY

Whenever sets of alternatives are open to us at the same point of time, we often make choices. Provided we are all rational beings, it can be said that, behind all activities, our basic motive is to maximize the total level of satisfaction. Whatever we choose in our daily life depends on the way we value it. For example, if you are given with alternatives, either to study Economics or to practice Mathematics, you will choose the alternative that gives you more satisfaction. Again, when the number of available alternatives is more than two we may choose a combination.

Here we have to understand the difference between preferences and choices. From a bunch of goods available to the consumer, there may exist a difference in his preference and choice. This is because; while we make preferences we only express our likes and dislikes. On the contrary, we choose something from the preferred alternatives that suits our budget best.

The concept of utility has been developed by economists to explain the basic principles of consumer choice and behavior. By utility we mean the extent of satisfaction obtained from the consumption of goods and services preferred by consumers. Given the available resources, the level of income, and market prices of various goods, the rational consumer allocates his spending in such a way that the preferred combination gives him the highest utility.

To compare the various goods available to the consumer, two basic approaches are followed; ‘the cardinal approach’ and ‘the ordinal approach’. According to the cardinal approach, utility can be measured in subjective units. Whereas, the ordinal approach implies that utility cannot be measured, but can only be ranked in order of preference. For example, let us consider that there are five goods, X1, X2, X3, X4 and X5, from which the consumer has to choose only one. Following the cardinal approach, let us assume that the amounts of utilities obtained from the various goods are:

Good                  Utility            Rank order

(in units)

  X1                        14                     2nd

 

X2                        03                     5th

 

X3                        10                     3rd

 

X4                        08                     4th

 

X5                        17                     1st

Here we choose the good X5 as it is measured to give the maximum amount of utility, i.e. 17 units. Whereas, following the ordinal approach, we would have ranked the available alternative in order of preference. So in ordinal approach instead of measuring the amount of utility obtained from the goods, we simply rank them in order to preference to match our choice.

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