What it means
Utility lets economists talk about preferences in a structured way. When a customer picks a coffee over a tea at the same price, we say the coffee gives them more utility.
People make choices to get the most utility from the money and time they have. An important idea is marginal utility, the extra satisfaction from one more unit of something.
The first slice of pizza is very satisfying, the third less so and the sixth may give almost nothing. This pattern, called diminishing marginal utility, explains why people pay less for extra units and why bulk discounts work.
Consumers are assumed to compare marginal utility per dollar across the things they could buy. If one more dollar spent on coffee gives more satisfaction than a dollar spent on snacks, they will shift spending towards coffee.
They stop shifting when the satisfaction per dollar is equal across choices. Businesses use these ideas whenever they set prices or design products.
Surveys, tests and sales data are used to learn what customers value, and the price is chosen to capture part of that value. Tiered pricing, bundles and loyalty rewards all rely on the idea that different customers get different utility from the same product.
In finance, utility also appears in expected utility theory, which describes how investors weigh risk against reward. Because an extra dollar is worth less to a wealthy investor than to a poor one, many people prefer a certain outcome to a gamble with the same average return.
This helps explain why insurance and diversification exist. Be careful with the second meaning.
A public utility is a business that provides essential services, usually under regulation because it often has no close competitor. When someone refers to utility stocks or utility bills, they mean this second sense, not satisfaction.
In practice
Real-world examples.
Example
A software firm offers a basic plan at $10 a month and a premium plan at $30. Customers who use the product heavily get far more value from the premium plan, so they are willing to pay the extra $20. The pricing team confirms this by checking how many customers upgrade after trying the premium features for free. The pricing team confirms this by checking how many customers upgrade after trying the premium features for free.
Example
A restaurant offers a free refill on soft drinks. Because the first drink gives the customer most of the satisfaction and a refill gives less, the extra cost to the restaurant is small compared with the goodwill it creates. The restaurant also tracks how often customers take a second refill, to make sure the cost stays low. The restaurant also tracks how often customers take a second refill, to make sure the cost stays low.
Example
An investor is offered a sure return of $50,000 or a coin-flip that pays $100,000 or nothing. Both have the same average of $50,000, but she takes the sure amount because the loss of the whole sum would hurt more than the extra gain would please her. Economists describe this as risk aversion and explain it with diminishing marginal utility of wealth.
Formula
Calculation
Marginal utility per dollar = marginal utility / price
Suppose a shopper gets 20 units of satisfaction (called utils) from one more coffee priced at $4, and 15 utils from one more snack priced at $2. The coffee gives 20 / 4 = 5 utils per dollar. The snack gives 15 / 2 = 7.5 utils per dollar. The shopper gets more satisfaction from spending on the snack, so shifting a dollar from coffee to snacks increases total utility until the two ratios are equal.Case study
Seen in the real world.
Sunvale Cinemas is an illustrative, fictional chain that sells tickets for $12 each. The manager notices that the early evening shows are half empty, while weekend nights are full.
She reasons that customers get less utility from a weekday show, because it is less convenient, so they will only pay a lower price. She introduces an $8 ticket for early weekday shows and keeps the weekend price unchanged.
In this illustrative story weekday attendance rises from 40 to 90 people a show. Revenue per show climbs from 40 x 12 = $480 to 90 x 8 = $720, and the manager concludes that matching the price to what customers value is more powerful than a single price. She also tests a $10 Tuesday ticket for families, and keeps whichever offer brings in more revenue per show. She also tests a $10 Tuesday ticket for families, and keeps whichever offer brings in more revenue per show.
Watch out
Common mistakes.
- Treating utility as a number that can be measured exactly, when it is a model used to explain choices.
- Confusing utility with usefulness, when something can give high satisfaction without being practical.
- Mixing up the economic term with public utilities, which are companies supplying water, power or gas.
Questions
People also ask.
What is marginal utility?
It is the extra satisfaction from consuming one more unit of a good or service.
Why does diminishing marginal utility matter to a business?
Because it explains why customers value extra units less, which supports volume discounts and bundles.
What is a public utility?
It is a company that provides essential services such as electricity, water or gas, and is usually regulated.
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