Question

explain in detail Utility Theory and its role in consumer choice and public decision making.

Answer 1

Utility theory is based on individual's preferences. It is a theory which explains behavior of individuals based on the premise people can consistently rank order their choices depending upon their preferences.

Utility theory is a positive theory that seeks to explain the individuals’ observed behavior and choices.

This contrasts with a normative theory, one that dictates that people should behave in the manner prescribed by it

To draw inferences from the prefernces of the people UTILITY FUNCTION is used to make inferences and represent them.

utility function is a mathematical formulation that ranks the preferences of the individual in terms of satisfaction different consumption bundles provide

The theory has two types utility

1. ordinal utility

2. cardinal utility

ORDINAL UTILITY

ordinal utility helps to study relative satisfaction levels.

CARDINAL UTILITY

cardinal utility, or utility that can represent the absolute level of satisfaction

ASSUMPTIONS

1. Completeness:

Individuals can rank order all possible bundles.Theory assumes that, no matter how many combinations of consumption bundles are placed in front of the individual, each individual can always rank them in some order based on preferences. This, in turn, means that individuals can somehow compare any bundle with any other bundle and rank them in order of the satisfaction each bundle provides

2. More-is-better:

Assume an individual prefers consumption of bundle A of goods to bundle B. Then he is offered another bundle, which contains more of everything in bundle A, that is, the new bundle is represented by ?A where ? = 1

3. Mix-is-better:

This assumption about preferences says that a mix of the two, say half-week of food mixed with half-week of clothing, will be preferred to both stand-alone choices.

4.Rationality:

Under the assumption of rationality, individuals’ preferences avoid any kind of circularity; that is, if bundle A is preferred to B, and bundle B is preferred to C, then A is also preferred to C. Under no circumstances will the individual prefer C to A