What is Utility Theory?

Definition: Utility theory is an economic hypothesis that postulates the fact that consumers make purchase decisions based in the degree of utility or satisfaction they obtain from a given item. This means that the higher the utility level the higher the item will be prioritized in the consumer’s budget.

What Does Utility Theory Mean?

This theory states that consumers rank products in their minds whenever they are facing a purchase decision. These ranking function drives their budget allocation, which means that resources are poured into the purchases that will bring the highest degree of satisfaction. It is assumed that individual budgets are limited and therefore there is a limited amount of goods or services that can be purchased, taking this into account, an individual will weigh which of the options currently available within the open market is the best suit to fulfill his current set of needs or desires.

In these cases, preferences also play a key role and these can be defined as a set of predispositions that each individual possesses towards certain brands or products by elements such as colors, shapes, tastes or smells. Finally, there are four essential types of utility and these are form utility, time utility, place utility and possession utility.

Example

Harold is a 45 year old computer engineer that was recently hired by a company called Tech Mogul Co. which is a firm that provide security solutions for information systems, mostly to the banking industry. Harold is considered to be a very sophisticated person who enjoys luxurious accessories and gadgets. His salary is big enough to allow him to purchase such items and he is normally up to date with new technological devices. Recently, Harold was presented with the new version of the smartphone he currently owns.

This new device costs $1,100 and it was offered to a few VIP clients of the firm. Even though there are other amazing smartphones available in the market, Harold prefers this new version because he is loyal to the brand. The utility he gets from this phone comes in the form of possession, as owning this new device makes him feel important and appreciated.