Law of diminishing marginal utility: Meaning, Criticisms & Real-World Uses

What Is the Law of Diminishing Marginal Utility?

The Law of Diminishing Marginal Utility is a fundamental principle in Microeconomics that states that as a person consumes additional units of a good or service, the additional satisfaction, or marginal utility, derived from each successive unit tends to decrease. This concept falls under the broader umbrella of consumer behavior and helps explain how individuals make choices about allocating their limited resources. Essentially, the more of something an individual has or consumes, the less additional satisfaction they gain from acquiring one more unit of it. This law is crucial for understanding consumer choice and how demand operates in markets.

History and Origin

The concept of diminishing marginal utility has roots in early economic thought, with various thinkers contributing to its development. One of the first to articulate the idea comprehensively was the German economist Hermann Heinrich Gossen in 1854⁸, ⁹, ¹⁰. His work laid foundational stones for what later became known as Gossen's First Law.

However, the idea gained significant traction and was formalized further by economists in the late 19th century during the "Marginal Revolution," most notably by Alfred Marshall. The notion of marginal utility also saw earlier discussions in the context of the St. Petersburg paradox, a problem posed by Nicolaus Bernoulli and later solved by his cousin Daniel Bernoulli in 1738. Daniel Bernoulli's solution introduced the concept that the value or utility of money to an individual diminishes as their wealth increases, thus anticipating the principle of diminishing marginal utility⁵, ⁶, ⁷. This historical evolution highlights how the understanding of human satisfaction and value influenced the development of modern economic models.

Key Takeaways

The Law of Diminishing Marginal Utility describes the decreasing additional satisfaction derived from consuming successive units of a good or service.
It is a core principle in Microeconomics, explaining aspects of consumer choice and demand.
This law implies that consumers are willing to pay less for additional units of a good as their consumption increases.
It helps explain the downward slope of the demand curve.
The concept is foundational to understanding utility maximization by consumers.

Formula and Calculation

While there isn't a single universal formula for the Law of Diminishing Marginal Utility, the concept is illustrated by observing how total utility changes with each additional unit consumed. Marginal utility (MU) is calculated as the change in total utility ((\Delta TU)) divided by the change in the quantity consumed ((\Delta Q)).

$MU = \frac{\Delta TU}{\Delta Q}$

As consumption of a good increases, the value of MU will typically decrease. For instance, if the first unit of a good provides 10 "utils" (a hypothetical unit of satisfaction) and the second unit provides only 8 additional utils, the marginal utility is diminishing.

Interpreting the Law of Diminishing Marginal Utility

The Law of Diminishing Marginal Utility suggests that individuals will spread their consumption across various goods rather than consuming excessive amounts of a single good, assuming scarcity of resources. For example, a person might enjoy one slice of pizza immensely, a second slice quite a bit, but by the fifth slice, the enjoyment gained from each additional slice significantly decreases, and might even become negative. This insight guides the understanding of why consumers diversify their purchases.

This principle is central to the theory of consumer equilibrium, which posits that consumers will allocate their budgets in such a way that the marginal utility per dollar spent is equal across all goods, a concept also known as the law of equimarginal utility.

Hypothetical Example

Consider a person, Sarah, who loves coffee. Her satisfaction from consuming coffee can be measured in hypothetical "utils":

First cup: Provides 20 utils of satisfaction.
Second cup: Provides an additional 12 utils (total 32 utils).
Third cup: Provides an additional 5 utils (total 37 utils).
Fourth cup: Provides an additional 1 util (total 38 utils).
Fifth cup: Provides -2 utils (total 36 utils – Sarah feels unwell from too much coffee).

In this scenario, the marginal utility of each successive cup of coffee decreases (20, 12, 5, 1, -2), demonstrating the Law of Diminishing Marginal Utility. Sarah's willingness to pay for each additional cup would likely decrease, reflecting the diminishing satisfaction. Her optimal consumption, from a utility perspective, might be the fourth cup, as the fifth cup brings negative marginal utility.

Practical Applications

The Law of Diminishing Marginal Utility has several practical applications in finance and economics:

Pricing Strategy: Businesses use this law to inform their pricing strategies. They understand that consumers are willing to pay more for initial units of a product due to higher marginal utility, but discounts or bulk pricing might be needed to encourage purchases of additional units.
Progressive Taxation: Progressive tax systems, where higher incomes are taxed at higher rates, can be partially justified by the idea that a dollar gained by a wealthy individual provides less marginal utility than a dollar gained by a lower-income individual.
Investment Decisions: While not a direct formula, the underlying principle of diminishing marginal utility can subtly influence investment decisions. As an investor's wealth grows, the marginal utility of money might diminish, leading to a potentially greater willingness to take on risk with a smaller portion of their overall portfolio, or a shift towards preserving capital rather than aggressive growth.
Consumer Choice Theory: The law helps explain why consumers, faced with a budget constraint and opportunity cost, diversify their purchases across various goods and services to maximize their total satisfaction from limited income. ⁴Consumers make utility-maximizing choices by considering the marginal utility per dollar for different goods.

Limitations and Criticisms

While widely accepted in traditional economics, the Law of Diminishing Marginal Utility, and utility theory in general, face some limitations and criticisms:

Measurability of Utility: Utility is subjective and difficult, if not impossible, to quantify objectively. Economists often use "utils" as a theoretical construct, but real-world measurement is elusive.
Exceptions: There are perceived exceptions, such as collecting rare items (where each additional item might increase satisfaction disproportionately due to completion) or addictive substances (where marginal utility might initially increase before diminishing). However, these can often be explained within the framework or as shifts in the individual's utility function.
Behavioral Economics Insights: The field of behavioral economics challenges the assumption of perfect rationality inherent in traditional utility theory. Researchers like Richard Thaler highlight how psychological biases, framing effects, and mental accounting can lead individuals to make decisions that do not align with strict utility maximization, even when the Law of Diminishing Marginal Utility would predict otherwise. ², ³For instance, people might value a gain of $10 less when part of a large transaction than when it represents a significant portion of a small transaction. ¹This branch of economics seeks to integrate psychological insights to offer a more nuanced understanding of decision-making.

Law of Diminishing Marginal Utility vs. Diminishing Returns

The Law of Diminishing Marginal Utility is often confused with the law of Diminishing returns, though they apply to different aspects of economics. The Law of Diminishing Marginal Utility refers to the satisfaction or utility a consumer gains from consuming successive units of a good or service. It's about consumer preferences and psychological satisfaction. In contrast, the law of diminishing returns (also known as diminishing marginal product) applies to production and states that adding more of one factor of production, while holding others constant, will eventually lead to smaller increases in output. For example, adding more workers to a fixed amount of land will eventually lead to a smaller increase in agricultural output per additional worker. The key distinction lies in what is "diminishing": satisfaction for the consumer versus productivity for the producer.

FAQs

What does "utility" mean in economics?

In economics, utility refers to the satisfaction, happiness, or benefit that a consumer derives from consuming a good or service. It's a subjective measure that economists use to understand consumer preferences and decision-making.

How does the Law of Diminishing Marginal Utility affect consumer purchasing decisions?

The Law of Diminishing Marginal Utility suggests that consumers will typically pay less for each additional unit of a good because the satisfaction they gain from it decreases. This influences how much of a product a consumer is willing to buy at different price points and helps explain the downward slope of a typical demand curve. It encourages consumers to diversify their consumption choices rather than concentrating all their spending on one item.

Is the Law of Diminishing Marginal Utility always true?

While it is a widely observed and fundamental principle in economics, there can be perceived exceptions or situations where its application is more complex, particularly as explored in behavioral economics. For instance, collecting items might seem to defy the law, as each new item could increase the value of the collection. However, for most common goods and services, the additional satisfaction from consuming more units tends to decline.

How is marginal utility different from total utility?

Marginal utility is the additional satisfaction gained from consuming one more unit of a good or service. Total utility is the cumulative satisfaction derived from consuming all units of a good or service. As marginal utility typically diminishes with each additional unit, total utility usually increases at a decreasing rate.