Utility Maximization

Individual Utility Maximization

According to the paradigm of neoclassical microeconomic theory, economists understand human behavior as a rational choice made from different alternatives under the conditions of scarcity. In other words, the individual compares all available options according to the differences between expected utility and cost (expected utility theory). Economists define cost as opportunity cost, the benefit forgone by employing a resource in a way that denies another use. For instance, the cost of higher education is not only tuition and expenditures for books but also the earnings that the student would have made if she were working rather than attending school. In principle, any [Page 1543]human behavior—even within the sphere of human relations—can be seen as a problem of scarcity and is therefore a potential field for economic research.

Microeconomic theory focuses on the individual as the subject of its analysis (so-called methodological individualism). Economists explain the behavior of social subjects as an aggregation of the behaviors of the respective members of the social group. Homo economicus represents the unit of economic analysis, the rational and self-interested economic person. The concept of rationality includes the proposition that individuals are able to act in accordance with their advantage, that they can evaluate their action field and make the best choice to maximize their utility. The self-interest theorem says that decision makers try to select from several alternatives the one that achieves the maximization of their own utility.

The utility that different goods generate is described by the utility function: U = U(x1, x2,…, xn). This means that the utility U depends on the quantities of goods that one can consume. Usually, the law of diminishing marginal utility (Gossen's First Law) is assumed. This states that the additional utility of one more consumed unit decreases with continuing consumption to zero and can even become negative. For instance, the utility of the first consumed cake is the highest; with the second and third cake, the additional utility will continually be smaller; and with the fourth, it becomes negative due to saturation. We exclude altruism, except where the well-being of other people is an argument in one's own utility function.

The typical textbook example of rational choice is the consumer's optimum: a household has to decide how it wants to spend its income on the purchase of goods. For the sake of simplicity, the example is limited to the choice between two goods, but the insights gained are also valid for any number of goods. The consumer's optimum of the household designates the combination of goods that generates the highest utility, given the consumer's expenditure. The utility U depends on the quantities of the two goods, x1 and x2 (for instance, apples and pears). One selects these in such a way that the utility becomes maximal. Therefore, the utility function is to

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