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Concepts: Economic Utility

Gunnar Jaerv
Gunnar Jaerv 1 July 2021

In marketing and sales, a common phrase is ‘sell the sizzle, not the steak.’ In other words, sell the appetizing aspects of the product, not what it actually is.

And in a way, that’s sound economic sense. When sales people point out that their product isn’t just a car, it’s a family vacation; not just a pair of boots, but a summer festival with dry feet; or not just a pan, but a tasty meal, they’re referencing the concept of economic utility.

When we buy something, we actually get several things. We get the object we paid for. We get the legal rights of possession over it. We become responsible for storing it. And we get access to the things it can do for us. Buy a truck with a big engine and you’re buying the ability to tow cars out of ditches, uproot stumps and cart gravel. That’s utility: the uses to which it can be put, and the satisfaction you expect to gain from that.

The four types of utility

Modern economic theory posits four main types of utility: form, time, place, and possession.

Form

Form utility refers to how well a product or service has been constructed to meet customers’ wants and needs. Companies now usually start with market research intended to identify and match these wants and needs and thus maximize form utility.

Time

Time utility is when a company tries to match the availability of a good or service with the time-based increases in desire among customers. For instance, in a majority-Muslim country in the month of Ramadan, snack bars won’t do much business in daylight hours; time utility is low because most consumers don’t eat then for religious reasons. But after dark, eating is permitted — and after a long hungry day, time utility is likely to be high.

Sales people are very sensitive to this concept, eagerly constructing processes that let them reply to potential customers quickly. They may couch it in different terms, but what they’re doing is maximizing time utility.

# Place Place utility refers to making goods or services physically available to potential customers. That can mean considerations of retail store premises locations, or it can mean design decisions as they apply to digital tools like a company’s website or app. The intention is always to have the customer’s route to value as uncluttered and clear as possible.

Possession

Possession utility is the amount of use or perceived value that a consumer or owner gets from possessing a product. Perceived value and cost, including opportunity cost, are in tension here, so you can raise possession value either by making the product more valuable (Porshce, not Honda Accord) or by making it easier to access (easy terms, no money down).

Possession utility is the type of utility most references to economic utility are concerned with, and the type this post will concentrate on.

Utility in modern economic theory

In modern economics, utility is a “utility function” — a utility calculation based on entirely subjective criteria that’s different for everyone, and thus far closer to the ordinal than to the cardinal conceptions of utility given above.

Each person calculates the utility they expect to derive from a given transaction versus the utility they expect to forego — price, opportunity cost, and so forth. This calculus is presumed to be subjective though many consumers will actually share much of it with each other.

Economic utility inheres not in the good or service itself, but in the relationship between the consumer’s wants and needs and the functionality of the good or service. To use a simple example, two meals when you’re hungry are not better than one. The second meal might be just as good as the first, but is much less useful to you if you already ate dinner.

To understand how we arrived at our modern understanding of utility, it can help to look at the history of the concept.

History of utility

Utility as an economic concept dates to the utilitarian philosophers Jeremy Bentham and John Stuart Mill. Both these thinkers, particularly Bentham, advanced a notion of ‘the good’ ( a key concern in philosophy) as whatever increased the sum of human happiness. Maybe you’ve heard the term “the greatest good for the greatest number”; maybe you’ve considered the ethical issues that might raise. We owe the phrase to Bentham.

Attempts to make utility something that could be calculated followed. Adam Smith’s work referred to it, and it’s a cornerstone of modern economics.

Ordinal utility

Ordinal utility as a concept can be traced back to the 13th-century Spanish Scholastic tradition, which defined the economic value of goods as deriving from a quality of usefulness. In common with the usual mediaeval approach this utility was thought to be qualitative (of different types) rather than quantitative (of different amounts).

In 1906, Italian thinker Vilfredi Pareto (yes, that Pareto) postulated the concept of utility in different terms. In Measuring Utility: From the Marginal Revolution to Behavioral Economics, Ivan Moscati explains that: “The fundamental notion of Pareto’s analysis was that of preference, and he conceived of utility as a numerical index expressing the preference relations between commodities”. In other words, with Pareto, utility became something in people, not in goods, and it became something you could count.

Later, the Austrian School expanded significantly on the concept, creating the ordinal theory of utility, suggesting that utility could best be understood as an ordering of preferences: A is preferable to B, which is preferable to C — each compared to the others, rather than to some universal standard.

Cardinal utility

With cardinal utility, we take a step away from preferences and towards an inherent property of goods and services. “Ordinal” “based on order”, while “cardinal” means “chief, principal, essential”. Cardinal utility inheres in products, and can be measured using a unit called a “util” — a single unit of utility. The concept of a measurable “util” makes it possible to treat transactions and other economic relationships using mathematical symbols and calculations.

Utils make it at least theoretically possible to measure satisfaction, including different satisfaction depending on scarcity. For example, to return to our meal example from earlier, the first slice of pizza may be highly satisfying — say, 15 utils. The next slice may be satisfying, but less pleasing — 10 utils, say. The next slice may provide just three utils of satisfaction. From such calculations are derived satisfaction curves and an attempt to quantify diminishing marginal utility (see below).

But “utils” are something of a legal fiction, or an imaginary number: they make it possible to do maths with economic utility, but they can’t be seen, detected as discrete items, or even measured — except by comparing the perceived value of one economic good with another.

This is a serious blow to the concept of cardinal utility; in modern economics, cardinal utility is usually viewed as subordinate to ordinal utility.

Marginal utility

Loosely put, marginal utility is the extent to which more is better. Owning three suits is better than owning two. Owning six is better yet. Owning six hundred is less of an improvement on six than owning six is on three. There aren’t six hundred occasions, or seasons, or types of weather, so when will you wear them?

More precisely, marginal utility is defined in cardinal terms as the additional utility gained from the consumption of an additional unit of a good or service, and in ordinal terms as the additional use that a given consumer has for each additional unit consumed.

The concept of diminishing marginal utility can’t be avoided here: marginal utility falls as additional units become available, while initial units retain high marginal value.

Theory of utility

The theory of utility states that, all other things being equal, a rational person will always choose the option that delivers the highest utility. This usually means selecting between options available at the time, though one of these is to hold off economic activity until a later date when another, higher-utility option may be available.

It is also worth observing here that human behaviour isn’t always fully rational, and neither is our idea of utility derived entirely from rational analysis; utility can tell us about what products or services enable us to do, but offers little guidance concerning what is desirable for us to do. We usually get that from other sources.

Utility, demand, supply and prices

Utility can be used to understand how demand curves operate, or to predict sales, set prices, or assess new purchases. Many of us already do this informally: how much use will you get out of that new item? And many of us do it at work, too: when we choose between two different software solutions for presentation, we’re selecting, at least in part, on the basis of utility. The companies might seek to offer us as much time, form, and place utility as possible, to persuade us to buy; but we’re likely to try to understand how much possession utility our purchase will deliver.

However, we can understand this in a more formal way too. Utility is the missing factor in formal demand-price curves that explains how the decisions they represent make sense to the consumer.

Conclusion

Utility, or usefulness, turns out to be a slipperier concept than it appears at first glance. We’re often buying several types of utility when we make a purchase, and even the appearance of being a good judge of economic choices — a wise purchaser, a discerning adopter of new technologies, or a careful shopper — can be seen as a form of utility! But without some understanding of what people get out of products and services, we lack a key piece of the economic puzzle.

Disclaimer:

Disclaimer: This publication is general in nature and is not intended to constitute any professional advice or an offer or solicitation to buy or sell any financial or investment products. You should seek separate professional advice before taking any action in relation to the matters dealt with in this publication. Please note our full disclaimer here.

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