Question

How does utility mazimization influence consumption decision making?

Answer 1

In microeconomics, utility represents a way to relate the amount of goods consumed to the amount of happiness or satisfaction a consumer gets. Marginal utility tells how much marginal value or satisfaction a consumer gets from consuming an additional unit of good. Microeconomic theory states that consumer choice is made on margins, meaning consumers constantly compare marginal utility from consuming additional goods to the cost they have to incur to acquire such goods. A consumer buys goods as long as the marginal utility for each additional unit exceeds its price. A consumer stops consuming additional goods as soon as the price exceeds the marginal utility.

In microeconomics, marginal utility and the law of diminishing marginal utility are the fundamental blocks that provide insight into the consumer choice of quantity and type of goods to be consumed. The law of diminishing marginal utility states the marginal utility from an additional unit of consumption declines as the quantity of consumed goods increases. Consumers choose their baskets of goods by equating marginal utility of a good to its price, which is a marginal cost of consumption.

The price a consumer is willing to pay for a good depends on his marginal utility, which declines with each additional unit of consumption, according to the law of diminishing marginal utility. Therefore, the price decreases for a normal good when consumption increases. The price and quantity demanded are inversely related, which represents the fundamental law of demand in consumer choice theory.

Utility maximization and its extension of expected utility maximization (von Neumann and Morgenstern, 1944) are the best developed formal notions of rationality and form the core of neoclassical economics. Utility maximization as such does not explicitly refer to the social context of action. It postulates a utility function, which measures the degree to which an individual's (aggregate) goals are achieved as a result of their actions. The rational actor chooses the action, from among those given, which maximizes utility given his (rationally formed) expectations. If the actor's goals are food and sleep, then rationality calls for choosing the attainable combination of food and sleep that yields the greatest utility. But the core theory does not specify the content of the utility function.

Without a concrete specification of what it is that generates utility, the theory has few refutable consequences since almost any choice can be rationalized by assuming a convenient goal. Thus, to increase the theory's empirical content additional assumptions must be made. Economic applications usually add the vastly oversimplified assumption that utility is measured by total income or wealth.

Without auxiliary assumptions, the theory is also silent about the processes used by the actors to find the optimal action. Neoclassical economics typically employs the assumption of perfect rationality in this respect. Rational actors never fail to find the action that maximizes their utility, even if this requires unlimited capacities to process and memorize all information available and to have unlimited foresight of the consequences of all available courses of actions in a distant future.