Ponderings on Utility

One of my favorite occurrences from this past quarter was when my Advanced Macro Prof Pete Klenow brought in his kids to class. Apart from being ridiculously cute, they also had a message to share with the class. Mrs. Klenow asked them what the purpose of Economics was and their well-rehearsed kids shouted that the purpose was “to maximize utility!”

And that brings me to the topic of this post, what is Utility really??

Now I’ve heard vague definitions such as the satisfaction an Econ (read: rational human, Econs are slightly different from Humans) received from consuming a good or service, or even more vague definitions such as utility is a proxy for happiness. Now there has been much criticism of GDP as a measure for welfare, and since GDP per capita growth is highly correlated with consumption per capita growth, I think we can safely say that consumption isn’t the sole determinant of overall welfare. In fact our Econ 52 class has at the least taught us that utility is a function of both consumption and leisure. Our prof Pete Klenow also is working on a paper (with Chad Jones who he claims is a future Nobel prize winner) on a different predictor of utility which you can check out here.

But what really determines utility? Do we care about things such as excitement vs. long-term satisfaction, so is a roller coaster ride going to add more to overall utility than working out (which is painful in the short-term but rewarding in the long-term). If we do value short-term utility more, going with the theme of ‘living in the moment’, then this would explain why we delegate all the ‘good’ stuff for later. For example, we want chocolate cake for dessert today because we’ll get back on our diet starting tomorrow. (This is also related to our behavioral tendency to discount hyperbolically, which is that we value the present a lot (and I meant A LOT) more than the future.) The question here is: does the sum of all these instances of short-term utility greater than longer lasting utility. So will a thousand pieces of chocolate cake (and the feeling of disgust the next day) outweigh the short-term pain of working out and the post-workout feeling of awesomeness? This is something most people should answer for themselves, but I think that the utility you get from being fit lasts longer, and assuming diminishing returns to both activities, the one with the longer impact should give you more overall utility.

I think along with many other people, I believe that there are several other determinants of overall utility other than consumption and leisure. Other determinants include those that allow you to maintain a certain quality of life, so for example having access to safe drinking water so that you’re not plagued with diarrhea would be nice. Other things include up to secondary school education, low infant mortality rates, high life expectancy etc.

I think one other factor that hasn’t been discussed as much includes relationships with other people. I think at the end of the day I would much rather have a best friend than a Ferrari. That’s just me though. Maybe there are diminishing returns to relationships as well, so maybe after having 4 best friends, I’d rather have a Ferrari than a 5th best friend. But its interesting how often people (myself included) prioritize current or future consumption for something that may give us more utility, ie. time to hang out with our friends and such.

Here is an interesting model that I’ve rambled about somewhere:

Now if we were to make a very simple model for relationships, lets say that utility is just a function of N, where N is the number of meaningful relationships we have. Lets assume that N has a positive utility and constant returns to scale (I honestly think that it has increasing returns to scale when N is low, for example I believe a meaningful relationship with a sibling equips us with the skills and stability to have a meaningful relationship with a friend; but for the simplicity of the model lets assume a linear relationship). Now we also have a budget constraint, and that is our time. Now it may be a very bad model to give a price for a relationship (in hours/day) since we aren’t taking into account consumption along with several other variables. But if we had a simple equation where u = F(N) such that Pn*N = Time, if we were to maximize utility we would basically try to have as many meaningful relationships as we can. But here is the problem, I was reading an article online (http://www.psychologytoday.com/blog/the-urban-scientist/200907/what-100000-people-really-think-you) which stated “A new survey shows that most people’s circle of confidants is on average about one person smaller now. And the percentage of people who say they have no one to confide in has now reached about 25%.”

Now lets assume the number of confidants we have is a good proxy measure for the number of meaningful relationships Americans have, that has decreased over time. So using this model, the math would say that the budget constraint is tighter in that most Americans just have less time. But thanks to empirical data, I know that Americans generally have more time than they did 20 years ago (this may not apply to college students). We know empirically that due to the income effect, most people nowadays have more leisure time than before, hence they have more time to form these meaningful relationships. Then why aren’t they doing so?

These are just some thoughts on utility. There is no overarching argument, but the theme of utility is sure to crop up in the future.

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A Good Ismaili is a Good Economist

So during the Golden Jubilee year (2007-2008), His Highness the Aga Khan was able to travel to see many Ismailies around the world. Now if you are unfamiliar with the term Ismaili, I suggest you click here.

During his travels, he had many messages to convey to Ismailis around the world and though many of them were timeless, I found only one to be extremely pertinent to 2007-2008. This message was that of frugality. December 2007 is the official month when the US recession started which has had several global effects, many OECD countries also fared pretty badly and most developing countries saw a slow-down in their growth.

Now back to the message of economic prudence, it was very simple: if you are a consumer then you should protect yourself from a future change in your income due to the economy. And if you are a producer, cut costs so you’ll be better positioned when the economic hardships start.

Well any forward looking consumer would have followed this advice without needing to be reminded. But not everyone is a homo economicus but instead we are homo sapiens, so it may be hard for many to have known the extent or magnitude of the recession and this sort of uncertainty may have delayed people’s consumption decisions. (And some of us wouldn’t have acted so even if we did know what the future held – its okay, self control and myopia are human problems).

Now here is some economics you should know: Marginal utility of consumption decreases as you consume more. Utility is a fancy name for satisfaction, and this first statement means that if you are really thirsty on a hot day and you consume two glasses of lemonade, the second glass won’t be as satisfying as the first glass. Consumers realize this, so they smooth their consumption over their lifetime. So instead of consuming all their income when they are earning the most in their 40’s (owning the fastest cars, living a lavish life) and then consuming nothing when they are retired, rational consumers spread out their consumption over their lifetime. So they’ll buy a Volvo instead of a BMW when they are rich, and be able to take trips to Florida instead of living on the street when they are poor.

Volvo's arent that bad actually

So a good Ismaili would have listened to this advice and acted like a good economist. They would have known that there is a good chance that their future income will decrease and so they would have known that their present value of lifetime resources (their net income over their life) will decrease. This in turn would cause them to decrease consumption slightly. So now lets say at the age of 30 a person was able to earn to $400,000 for the rest of their life and they intend to only live to be 70, so they would spend $400,000/40= $10,000 per year. But if they see that over the next two years their income decreases by $10,000 in each year, that doesn’t mean they decrease consumption by $10,000 each year. Instead their new smooth consumption would be 400K-20K/40 = 9.5K, so instead of decreasing their consumption by $10,000 for two years they decrease their consumption by $500 for the rest of their life.

Consumption Smoothing

So a Good Ismaili would listen to this sound economic advice to live frugally and reduce consumption; thus acting like a good economist. (In case you were wondering, the opposite does not hold, a good economist doesn’t make a good Ismaili).