Monday  January 21, 2019
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 RISK POOLING: Combining the uncertainty of individuals into a calculable risk for large groups. For example, you may or may not contract the flu this year. However, if you're thrown in with 99,999 other people, then health-care types who spend their lives measuring the odds of an illness, can predict that 1 percent of the group, or 1,000 people, will get the flu. The uncertainty is that they probably don't know which 1,000 people, they only know the number afflicted. This little bit of information is what makes risk pooling possible. If the cost is \$50 per illness, then an insurance company can insure your 100,000-member group against flu if they collect \$50,000 (\$50 x 1,000 sick people), or 50 cents per person. By agreeing to pay the cost of each sick person in exchange for the 50 cent payments, the insurance company has effectively pooled the risk of the group.

UTILITY ANALYSIS:

A subset of consumer demand theory that analysis consumer behavior and market demand using total utility and marginal utility. The key principle of utility analysis is the law of diminishing marginal utility, which offers an explanation for the law of demand and the negative slope of the demand curve.
Utility analysis, a subset of consumer demand theory, provides insight into an understanding of market demand and forms a cornerstone of modern microeconomics. In particular, this analysis investigates consumer behavior, especially market purchases, is based on the satisfaction of wants and needs (that is, utility) generated from the consumption of a good.

Utility analysis is primarily taught in introductory courses. A more sophisticated version of consumer demand theory relies on the analysis of indifference curves and is more commonly found at the intermediate course level and above.

### Utility and Satisfaction

The primary focus of utility analysis is on the satisfaction of wants and needs obtained by the consumption of goods. This is technically termed utility. The utility generated from consumption affects the decision to purchase and consume a good.

When used in the analysis of consumer behavior, utility assumes a very precise meaning, which differs from the everyday use of the term. In common use, the term utility means "useful." For example, a "utility" knife is one with many uses, something that is handy to have around. In baseball, a "utility" player can perform quite well at several different positions and is thus useful to have on the team. Moreover, a public "utility" is a company that supplies a useful product, such as electricity, natural gas, or trash collection.

In contrast, the specific economic use of the term utility in the study of consumer behavior means the satisfaction of wants and needs obtained from the consumption of a commodity. The good consumed need not be "useful" in the everyday sense of the term. It only needs to provide satisfaction.

In other words, a frivolous good that has little or no practical use, can provide as much utility as a more useful good.

• An OmniOpen Deluxe Can Opener is extremely useful, especially when a sealed can needs to be opened.

• An autographed photo of Brace Brickhead, Medical Detective, is not very useful. It does nothing but rest peacefully in a picture frame.
Both items, however, provide utility. Both items satisfy wants and needs. The OmniOpen Deluxe Can Opener obviously makes it possible to open cans of food which satisfy the hunger need. The autographed photo of Brace Brickhead provides the owner with a warm, fuzzy feeling and a reminder of the time spent enjoying the thrilling exploits of Brace Brickhead, Medical Detective.

### The Law of Demand

The primary focus of utility analysis is an understanding of market demand and the law of demand. The law of demand, which gives rise to a negatively-sloped demand curve, is an essential principle underlying market analysis. Modern microeconomic theory, among other topics, is concerned with understanding and explaining the law of demand.

The explanation of the law of demand using utility analysis is relatively simple. Consumers purchase goods that satisfy wants and needs, that is, generate utility. Those goods that generate more utility are more valuable to consumers and thus buyers are willing to pay a higher price. The key to the law of demand is that the utility generated declines as the quantity consumed increases. As such, the demand price that buyers are willing to pay decreases as the quantity demanded increases.

### Total Utility

Total Utility
Utility analysis begins with the total utility derived from the consumption of different quantities of a good. Total utility is simply a measure of the total satisfaction of wants and needs obtained from the consumption or use of a good or service. It is often convenient to present total utility for a range of quantities in a table such as the one displayed to the right.

Utility analysis is based on the presumption that the amount of utility generated from the consumption of a good can be explicitly measured. The standard hypothetical measurement unit is "utils."

Suppose, for example, that Edgar Millbottom spends a day riding the Monster Loop Death Plunge roller coaster at the Shady Valley Amusement Park, then records the amount of total utility achieved at the end of each ride. The two columns presented in the table measure the number of rides and the total utility accumulated by Edgar at the end of each ride (in utils).

• Before his first ride, Edgar receives no utility. No activity, no utility.

• Edgar's first ride generates 11 utils of utility.

• The total utility generated if Edgar takes 8 rides is 32 utils.

• Edgar's utility increases for the first 6 rides, reaching a high of 36 utils, before declining back to 32 utils for the 8th ride.

• Presumably Edgar's utility continues to decline after the 8th ride.

• Edgar obtains the highest total utility from 6 rides on the roller coaster.
The motivation that guides Edgar's roller coaster riding is to maximize utility, that is, to consume the quantity of the good that generates the highest level of utility. In this example, utility is maximized at 6 rides.

In many situations, however, the consumption of a good faces constraints. Edgar, for example, might face a time constraint because he plans to attend a live concert of the rock-and-roll group, Live Headless Squirrels, that prevents him from riding more than 4 times. Or he might face an income constraint because the amusement park charges \$1 per ride and he has only \$5 in his pocket.

In these situations Edgar, as well as other consumers, might pursue constrained utility maximization. This means achieving the highest possible utility, given certain restrictions that prevent the highest overall level of utility from being achieved.

### Marginal Utility

Total utility is used as a starting point for utility analysis. However, a great deal of additional insight is gained from marginal utility. Marginal utility is the additional utility, or extra satisfaction of wants and needs, obtained from the consumption or use of an additional unit of a good or service. Marginal utility is, in other words, the extra satisfaction gained from an extra unit of good.

Marginal utility is specified as:

 marginal utility = change in total utilitychange in quantity

If, for example, total utility increases from 20 to 27 utils, then marginal utility is 7 utils.

Marginal Utility
The far right column of this table presents marginal utility values derived from each ride Edgar undertakes. Marginal utility from the first ride is 11 utils. The extra utility generated by the second ride is 9 utils. The third ride provides another 7 utils. The remaining numbers in the right column are interpreted in a similar manner.

Marginal utility provides a direct link between utility analysis and demand. The demand price a buyer is willing to pay for a given good is based on the marginal utility derived from consuming the good. In this example, Edgar is most likely willing is to pay more for the first ride than the fifth ride, in that the first ride generates 11 utils of satisfaction, but the fifth ride generates only 3 utils.

### The Law of Diminishing Marginal Utility

A clear pattern is displayed by the marginal utility values in the far right column. Marginal utility decreases as Edgar takes more rides. This decreasing marginal utility reflects the law of diminishing marginal utility. The law of diminishing marginal utility states that marginal utility, or the extra utility obtained from consuming a good, decreases as the quantity consumed increases. In essence, each additional good consumed is less satisfying than the previous one. This law is particularly important for insight into market demand and the law of demand.

If each additional unit of a good is less satisfying, then a buyer is willing to pay less. As such, the demand price declines. This inverse law of demand relation between demand price and quantity demanded is a direct implication of the law of diminishing marginal utility.

 <= UTILITY UTILITY MAXIMIZATION =>

Recommended Citation:

UTILITY ANALYSIS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2019. [Accessed: January 21, 2019].

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