Utility Theory - Chapter 6 Utility Theory Utility Theory...

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Chapter 6: Utility Theory Utility Theory allows us to develop a framework (or mode of analysis) whereby a consumer with a limited budget is able to buy a bundle of goods and services such that his or her satisfaction ( utility ) from the consumption of the bundle is maximized. Additionally, it allows us to understand why the demand curve is downward sloping. Concepts and Variables Involved in Utility Theory The most fundamental concept of Utility Theory is that of the util. A util is the basic unit of measurement of satisfaction derived from the consumption of a good or service. All variables involved with Utility Theory are measured in units of utils. The total utility (TU) of a product is the total amount of satisfaction derived from the consumption of a product. It is measured in utils. The marginal utility (MU) is the additional utility derived from the consumption of one additional unit of a product. It is also measured in utils. Diminishing marginal utility (DMU) refers to the fact that for each additional unit of a product consumed, less and less satisfaction will be gained. This causes marginal utility to continuously decrease. Applications of Utility Theory In order to apply Utility Theory, it is essential to make two assumptions. The first assumption is that each consumer knows exactly how many utils he or she derives from the consumption of a product.
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