What is the Utility Theory in Economics?
Utility theory is a theory in economics that emphasizes individuals’ choices. This theory explains the behaviour of individuals based on the idea that people make choices based on preferences. Each individual has a different preference. Thus, everyone will make personalized decisions. These preferences are inherent to each individual and not changeable.
Utility theory seeks to explain how individuals’ decisions and behaviours can change based on their preferences. The primary focus of the utility theory is that individuals will prefer decisions that provide the most utility for their given preferences. In some cases, measuring utility from a given decision may not be possible. However, this theory assumes that individuals behave as if they make a decision by assigning an imaginary number to it.
According to the utility theory, individuals translate different levels of monetary values into “utils”. Util is a hypothetical unit that measures utility. Then the individual processes the decision in utility terms. These terms may often contradict the generation of wealth as some individuals have different goals. Based on that utility approach, investors make a decision.
What is Utility?
Utility in economics represents the total satisfaction that consumers get from the use of goods or services. It measures the benefit that consumers can extract from specific goods or services. However, quantifying the utility that consumers get from goods or services is challenging. Despite that, there are several economic models that attempt to measure it.
Most of these models that believe in rational choice assume that investors will always extract the maximum utility from goods or services. However, utility isn’t a concept that only applies to economics. It also has its application in finance and investing. In finance, utility refers to how much investors can benefit from their portfolio’s performance.
How does utility apply to finance?
As with utility in economics, utility in finance also assumes that investors will seek to maximize their utility. In this case, the utility comes in the form of returns from the portfolio. Therefore, utility in finance relates to the high returns that investors expect from their investments. However, these high returns also come with risks. Usually, there is a direct relationship between both of these concepts.
Due to the high risk on high return investments, investors also face the possibility of making substantial losses. Therefore, investors need to understand the utility they can get from various investments. This way, they can make better decisions and choose stocks that meet their requirements. The utility theory in finance assumes that, given a choice, investors will select the highest return investment option. However, they will also factor in their risk attitude.
What are the assumptions made by the Utility Theory?
The utility theory assumes that individuals can rank all decisions in some order based on their preferences. Similarly, this theory also presumes that individuals will also prefer more utility to less utility. The utility theory also makes the convexity assumption on preferences, suggesting that preferences are convex. Lastly, this theory assumes that all individuals base their decisions on rationality.
Conclusion
The utility theory in economics seeks to explain individuals’ behaviours based on preference. This theory suggests that individuals seek value in everything and use that to make decisions. The utility theory in economics also applies to finance. In that case, it looks at how individuals base their decisions based on risks and returns.
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