This post clarifies the concept of a utility function, which occupies a very significant position in neoclassical microeconomics. Advances in Neuroeconomics (Neuroeconomics combines psychology, economics, and neuroscience, to study how people make decisions. It looks at the role of the brain when we evaluate decisions, categorize risks and rewards, and interact with each other. It can be included in the field of social neuroscience) and related fields of behavioural economics is constantly challenging the conventional assumptions of microeconomics. This post takes up one such insight by Stephen B Hanauer which was published in Nature in March 2008.
A utility function can be understood in the following way:
U=f(x,y,z) where U is the utility derived from the consumption of x, y and/or z. Alternatively, a utility function transforms combinations of various goods into a single value. Note that x,y and z refer to ‘quantities’ of goods/services consumed.
Suppose, consumer A has the following utility function: U=x+y+z; arbitrary values of x,y and z would result in the following values of U.
| x | y | z | U |
| 0 | 0 | 0 | 0 |
| 1 | 0 | 0 | 1 |
| 10 | 10 | 0 | 20 |
| 6 | 6 | 8 | 20 |
| 0 | 10 | 10 | 20 |
| 10 | 10 | 10 | 30 |
That is, microeconomics teaches us that the utility of the consumer is determined by the quantity of goods consumed. An common assumption is that ‘more is better’, which implies that the consumption of more goods gives the consumer more utility. The point to be noted is that microeconomic theory teaches us that utility is strictly a function of quantities. The question posed in this post is whether utility is ‘only’ a function of quantities. What happens if utility is also a function of prices? At this juncture, we need to recollect the objective of utility functions. From the utility function, we derive indifference curves and marginal utilities. Utility or use value of the good or service forms the basis of the demand function, which along with the supply function determines the value/price of a commodity or service. Thus, the use value was employed so as to arrive at the exchange value/relative price of the commodity.
What happens if utility (or experienced pleasantness) is influenced by “changing properties of commodities, such as prices”? That is, can neoclassical microeconomics accomodate the following utility function:
U=f(x,y,Px,Py)
And research in behavioural economics and related areas suggest that prices exert a significant influence on utility and hence on choice and demand. However, if we accept such a utility function, it can no longer be used to explain exchange values/relative prices. Another implication is that prices are no longer determined by the interaction of demand and supply. And the statement that ‘consumer is the king’ no longer holds. Also, producers can adjust prices in such a way as to affect consumers’ utilities. We know that high prices are often associated with better quality and hence higher utility.
| x | y | Px | Py | U |
| 0 | 0 | 10 | 10 | 0 |
| 10 | 10 | 10 | 10 | 200 |
| 10 | 10 | 5 | 10 | 150 |
| 10 | 10 | 4 | 4 | 80 |
The above table can be explained by the following utility function: U=x.Px + y.Py
In this case, a higher price gives more utility to the individual. The maximum utility is when x=y=10 and Px=Py=10.
The other extreme case is when high prices are detested by the individual. For instance, consumers with low incomes will get more utility from consuming goods which are priced less. Their utility function could be represented as follows: U=x.-Px + y.-Py
In which case, the consumers utilities based on the previous values of x,y,Px and Py will be 0, -200, -150 and -80. And the consumer’s utility is maximum when he/she consumes x=y=10 when Px=Py=4.
Empirical evidence suggests that utility is equally influenced by prices of commodities as well. Does this threaten the core of neoclassical microeconomics? This is problematic because neoclassical economics assumes the following to be given: 1) tastes and preferences of individuals, 2) endowments of goods and 3) constant technology. It if from these ‘givens’ that prices and quantities (demanded and supplied) are arrived at through the mechanism of demand and supply/competition/market forces. How can we include the recent findings pertaining to consumer utility and satisfaction in a consistent manner?
