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Utility Maximization

The concept that individuals and organizations seek to attain the highest level of satisfaction from their economic decisions

What is Utility Maximization?

Utility maximization is a strategic scheme whereby individuals and companies seek to achieve the highest level of satisfaction from their economic decisions. For example, when a company’s resources are limited, management will implement a plan of purchasing goods or services that provides the maximum benefit.

 

Utility Maximization

 

The concept of utility maximization was developed by the utilitarian philosophers Jeremy Bentham and John Stuart Mill. It was incorporated into economics by English economist Alfred Marshall. An assumption in classical economics is that the cost of a product that a consumer is willing to pay is an approximation of the maximum utility that they receive from the purchased good.

 

Summary

  • Utility maximization is the concept that individuals and organizations seek to attain the highest level of satisfaction from their economic decisions.
  • Utility function measures the intensity to which an individual’s fulfillment is met.
  • Economic utility decreases with the increase in the consumption of a good or service.

 

Understanding Utility Maximization

The combination of goods or services that maximize utility is determined by comparing the marginal utility of two choices and finding the alternative with the highest total utility within the budget limit. The decision is influenced by the option that produces a higher level of satisfaction. This explains how companies and individuals develop consumption habits.

The consumer may consider purchasing more of one item and less of another. Through maximizing utility, the consumer will buy an item that produces the greatest marginal utility with the least amount of spending.

For example, if product ‘A’ comes with twice more marginal utility than product ‘B,’ that means product ‘A’ is providing more marginal utility per dollar than ‘B.’ As a result, the consumer may decide to buy more of product ‘A.’

The utility-maximizing rule is expressed as follows:

 

Utility Maximizing Rule

 

Total Utility Maximization

Total utility refers to the total amount of satisfaction that a person obtains by consuming a specific quantity of units of a product at a given time. The greater the consumer’s total utility, the higher the measure of satisfaction acquired.

Total utility is used to determine a consumer’s decision based on utility maximization in the economic setting. A company’s management should make production changes by analyzing the marginal utility increase or decrease.

Consumers try to maximize their utility with every item consumed based on rational choice theory. Their decisions are geared toward acquiring the most affordable items with the highest level of satisfaction.

Generally, consumer behavior is based on maximizing total utility by acquiring units that enable them to gain maximum utility for the amount they spend. This is partially due to the budget constraints and the desire to achieve as much satisfaction as possible from the consumption of a product.

 

Calculating Total Utility Maximization

Each unit of a product or service has its utility, while every additional unit of consumption has its marginal utility. The total utility equation assigns base values called utils. Economists examine utils over a broad range and determine the level of satisfaction gained from a particular unit of consumption. An allocated constant unit for utils is set since there is no actual figure for utility satisfaction.

The formula below is used in calculating total utility maximization:

 

TU = U1 + MU2 + MU3…

 

Where:

  • TU is Total Utility
  • U is Utility
  • MU is Marginal Utility

 

The total utility is equivalent to the number of utils realized from each unit of consumption. However, the theory assumes that every additional unit of consumption generates less marginal utility, which is the law of diminishing marginal utility.

 

Marginal Utility Maximization

Marginal utility refers to the additional satisfaction that a consumer achieves from utilizing one additional item. For example, if the utility of consuming the first cake is ten utils and eight utils for the second cake, the marginal utility of consuming the second cake is eight utils. If two utils are assigned to the utility of the third cake, then the marginal utility of consuming the third cake is two utils.

Generally, a customer will consume a product up until the marginal utility is equal to zero. That is, if the cake provides more satisfaction than the cost, then the consumer will continue buying it.

The objective of marginal utility is to determine the quantity of a product that the consumer is willing to buy. Individuals and companies make decisions regarding their utility. If a certain item comes with marginal utility, the consumer will continue to purchase more of that good.

However, if the utility of that product declines with the consumption of each subsequent additional unit, then the consumer will stop when marginal utility reaches zero or becomes negative.

 

Additional Resources

CFI offers the Certified Banking & Credit Analyst (CBCA)® certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

  • Consumer Surplus
  • Expected Utility
  • Marginal Benefit
  • Neoclassical Economics

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Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!

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