EBF 200
Introduction to Energy and Earth Sciences Economics

 

Utility and Individual Rationality

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As outlined in the previous section, we are trying to study why people make the economic decisions that they make. To try to understand this question, we assume that people do things that make them happy. This is not a difficult concept to understand: any time we are faced with a choice, there is an outcome that will make us happier than another outcome. Some choices are not very enjoyable, such as doing our laundry or paying our taxes, but we do so because the alternative will leave us with less happiness: most of us prefer clean clothes to dirty, and most of us prefer to not be hounded into court by the taxman.

Economists don't use the word "happiness," but instead have coined another term: "utility." You might think of a utility as the company that provides your electricity or drinking water, and these have the same root meaning derived from the word "use." In the economic context, think of utility as the use, or the value of the use, or the happiness derived from the use of some good. Basically, "utility" is the economic catch-all term for whatever benefit we get from consumption of some economic good, or in a broader sense, the benefit we derive from the outcome of an economic decision.

So, if somebody gets utility from making a decision, and more utility (happiness) is unambiguously better than less, then we make the claim that people are "rational utility maximizers." That is, in every decision that we make, we think rationally about the outcomes and make the choice that gives us the most utility. This is a simple and elegant statement, and it lies at the foundation of modern western economic thought, but it is not completely uncontroversial or even all that uncomplicated. For example, many decisions are not simple yes/no or A/B choices. Sometimes there are many possible choices - indeed, there are usually many possible choices, and we don't always know which of those choices will make us happier for the simple reason that we cannot see the future with perfect foresight. People make uninformed decisions, hurried decisions, unlucky decisions, just plain wrong decisions every day. We are not perfectly rational, and we usually do not have either the time or the knowledge or foresight to always make the correct decision. This is an area of intense study at the boundaries of contemporary economic thought - several of the recent Nobel prizes in economics have gone to people researching what is called "behavioralism," a field of study that spans economics, psychology, and neurology. In other words, it gets really complicated. So, we make the assumption that people are rational utility maximizers. It may not be perfectly true, but it is reasonably defensible (most of us try to make the best decisions most of the time, and we don't deliberately do things that will hurt ourselves). Most importantly, it gives us a firm foundation to build upon. It is what we call a "simplifying assumption": we can assume it to be true, and doing so will allow us to answer a broad swath of questions about economic decision making and outcomes. And after we have reasonably answered all of those questions, we can start relaxing our assumptions one at a time to see how the outcome changes. It turns out that, even if you relax the assumption of perfect rationality, most of the answers to the questions do not change in a meaningful or substantive manner.

Money and Utility

It is important to state at this point that money and utility are not the same thing. People are not money-maximizers; for example, most of us would rather have the weekends off instead of working a second job. I could take a second job working in a restaurant at night, but I get more happiness spending my evenings at home or out with my family.

However, in this course, and in almost any other study of economics, you will find utility defined in terms of money. This action is defined as "monetization." This is not because we believe that money is everything. It is because we are lazy and want to explain things in simple terms. So, what we are using is using money as a common unit of measure and accounting. For example, for my winter vacation choice, I could go skiing or go to a beach resort in Mexico. In order to measure the happiness obtained from these two choices, we need a common unit of measure, and since money is a universally accepted proxy as a measure of value, that is what we use. So, economists talk about everything in terms of money because doing so makes our lives (and those of students) easier.