Utility Theory.html

Utility Theory

Economists use utility theory to study consumer behavior in an effort to explain why consumers will purchase more of a company’s goods only if the prices are lowered. In other words, basic utility theory explains that as you consume increasing amounts of a product, you receive decreasing utility from each additional unit consumed and must be motivated to consume even more of the product. This concept is called the law of diminishing marginal returns. For this reason, a company has to convince potential buyers that they will gain utility from buying more of its product.

“Substitutes are goods and services that can be used to fill a similar need or desire.  Goods and services that become more desirable when consumed together are called complements. Going to the movies and renting a DVD are close substitutes. At the same time, many consumers like to consume buttered popcorn and soda at the movie theater. Movies, buttered popcorn, and soda are often complements” (Hirschey, 2009, 156).

“Insight into the indifference curve concept can be gained by considering what indifference curves look like for the logical extremes of perfect substitutes and perfect complements. Perfect substitutes are goods and services that satisfy the same need or desire. Perfect complements are goods and services consumed together in the same combination” (Hirschey, 2009, 156).

Reference:

Hirschey, M. (2009). Fundamentals of managerial economics, (9th ed.). Boston, MA: Cengage Learning.

Economists use indifference maps to explain consumer buying habits in terms of the concept of utility. It is important to remember that budget is a constraint for most consumers, forcing them to select different combinations of the goods in question in order to reach the highest level of satisfaction, resulting in the highest indifference curve.