Utility Maximization - Overview, How It Works, Calculation

Utility maximization is a strategic scheme whereby individuals and companies seek to achieve the highest level of satisfaction from their ... Home›Resources›Knowledge›Economics›UtilityMaximization UtilityMaximization Theconceptthatindividualsandorganizationsseektoattainthehighestlevelofsatisfactionfromtheireconomicdecisions Writtenby CFITeam UpdatedFebruary5,2022 WhatisUtilityMaximization? Utilitymaximizationisastrategicschemewherebyindividualsandcompaniesseektoachievethehighestlevelofsatisfactionfromtheireconomicdecisions.Forexample,whenacompany’sresourcesarelimited,managementwillimplementaplanofpurchasinggoodsorservicesthatprovidesthemaximumbenefit. TheconceptofutilitymaximizationwasdevelopedbytheutilitarianphilosophersJeremyBenthamandJohnStuartMill.ItwasincorporatedintoeconomicsbyEnglisheconomistAlfredMarshall.Anassumptioninclassicaleconomicsisthatthecostofaproductthataconsumeriswillingtopayisanapproximationofthemaximumutilitythattheyreceivefromthepurchasedgood. Summary Utilitymaximizationistheconceptthatindividualsandorganizationsseektoattainthehighestlevelofsatisfactionfromtheireconomicdecisions. Utilityfunctionmeasurestheintensitytowhichanindividual’sfulfillmentismet. Economicutilitydecreaseswiththeincreaseintheconsumptionofagoodorservice. UnderstandingUtilityMaximization Thecombinationofgoodsorservicesthatmaximizeutilityisdeterminedbycomparingthemarginalutilityoftwochoicesandfindingthealternativewiththehighesttotalutilitywithinthebudgetlimit.Thedecisionisinfluencedbytheoptionthatproducesahigherlevelofsatisfaction.Thisexplainshowcompaniesandindividualsdevelopconsumptionhabits. Theconsumermayconsiderpurchasingmoreofoneitemandlessofanother.Throughmaximizingutility,theconsumerwillbuyanitemthatproducesthegreatestmarginalutilitywiththeleastamountofspending. Forexample,ifproduct‘A’comeswithtwicemoremarginalutilitythanproduct‘B,’thatmeansproduct‘A’isprovidingmoremarginalutilityperdollarthan‘B.’Asaresult,theconsumermaydecidetobuymoreofproduct‘A.’ Theutility-maximizingruleisexpressedasfollows: TotalUtilityMaximization Totalutilityreferstothetotalamountofsatisfactionthatapersonobtainsbyconsumingaspecificquantityofunitsofaproductatagiventime.Thegreatertheconsumer’stotalutility,thehigherthemeasureofsatisfactionacquired. Totalutilityisusedtodetermineaconsumer’sdecisionbasedonutilitymaximizationintheeconomicsetting.Acompany’smanagementshouldmakeproductionchangesbyanalyzingthemarginalutilityincreaseordecrease. Consumerstrytomaximizetheirutilitywitheveryitemconsumedbasedonrationalchoicetheory.Theirdecisionsaregearedtowardacquiringthemostaffordableitemswiththehighestlevelofsatisfaction. Generally,consumerbehaviorisbasedonmaximizingtotalutilitybyacquiringunitsthatenablethemtogainmaximumutilityfortheamounttheyspend.Thisispartiallyduetothebudgetconstraintsandthedesiretoachieveasmuchsatisfactionaspossiblefromtheconsumptionofaproduct. CalculatingTotalUtilityMaximization Eachunitofaproductorservicehasitsutility,whileeveryadditionalunitofconsumptionhasitsmarginalutility.Thetotalutilityequationassignsbasevaluescalledutils.Economistsexamineutilsoverabroadrangeanddeterminethelevelofsatisfactiongainedfromaparticularunitofconsumption.Anallocatedconstantunitforutilsissetsincethereisnoactualfigureforutilitysatisfaction. Theformulabelowisusedincalculatingtotalutilitymaximization: TU=U1+MU2+MU3… Where: TUisTotalUtility UisUtility MUisMarginalUtility Thetotalutilityisequivalenttothenumberofutilsrealizedfromeachunitofconsumption.However,thetheoryassumesthateveryadditionalunitofconsumptiongenerateslessmarginalutility,whichisthelawofdiminishingmarginalutility. MarginalUtilityMaximization Marginalutilityreferstotheadditionalsatisfactionthataconsumerachievesfromutilizingoneadditionalitem.Forexample,iftheutilityofconsumingthefirstcakeistenutilsandeightutilsforthesecondcake,themarginalutilityofconsumingthesecondcakeiseightutils.Iftwoutilsareassignedtotheutilityofthethirdcake,thenthemarginalutilityofconsumingthethirdcakeistwoutils. Generally,acustomerwillconsumeaproductupuntilthemarginalutilityisequaltozero.Thatis,ifthecakeprovidesmoresatisfactionthanthecost,thentheconsumerwillcontinuebuyingit. Theobjectiveofmarginalutilityistodeterminethequantityofaproductthattheconsumeriswillingtobuy.Individualsandcompaniesmakedecisionsregardingtheirutility.Ifacertainitemcomeswithmarginalutility,theconsumerwillcontinuetopurchasemoreofthatgood. However,iftheutilityofthatproductdeclineswiththeconsumptionofeachsubsequentadditionalunit,thentheconsumerwillstopwhenmarginalutilityreacheszeroorbecomesnegative. AdditionalResources ThankyouforreadingCFI’sguideonUtilityMaximization.Tokeeplearninganddevelopingyourknowledgebase,pleaseexploretheadditionalrelevantresourcesbelow: ConsumerSurplus ExpectedUtility MarginalBenefit NeoclassicalEconomics Sharethisarticle GetCertifiedfor
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