The law of diminishing marginal utility
Diminishing marginal utility
The law of diminishing marginal utility1 suggests that as more units of a product are consumed the marginal (additional) benefit of each extra unit to the consumer falls, meaning that rational consumers are prepared to pay less for these marginal units.
Diminishing marginal utility
The principle of diminishing marginal utility suggests that:
- Most benefit from consumption is generated by the first unit of a good or service consumed. This is because the first unit satisfies most or all of the immediate need or desire. For example, for coffee drinkers, the first coffee of the day is commonly regarded as the 'best'.
- A second unit consumed is likely to generate less utility given that the consumer has less need or desire - in extreme cases, all the utility from consumption comes with the first unit, and a second would give zero benefit. Once an individual has had a hair cut, a second one would give no utility - (at least, not until its needed). With less benefit derived, the rational consumer is prepared to pay rather less (or nothing) for the second, and subsequent, units, given that the marginal utility falls.
Example
Consider the following figures for utility derived by an individual when consuming bars of chocolate. While total utility continues to rise from extra consumption, the additional (marginal) utility from each bar falls, and becomes negative after 5 bars!
We can show total and marginal utility graphically. While total utility increases, it does so at a declining rate, and eventually starts to turn downwards as the sixth bar of chocolate creates a 'dis-utility'.
In this case, the marginal utility falls immediately [and provides the gradient for the total utility curve]. Where total utility is at a maximum, marginal utility is zero.
While the marginal utility starts to decline from the second unit onwards, it is possible that, for certain goods, marginal utility rises at first before diminishing. The commonly quoted examples include 'collectables' and some movies. In the case of a set of six antique dining chairs, an individual may already have five, and finding and purchasing the sixth in the set may well provide more utility than the first! Similarly, for many different reasons, watching a movie for the second time may provide more entertainment than the first watching.
Despite this, the concept of diminishing marginal utility provides a sound starting point for understanding consumer behaviour, including explaining why demand curves slope downwards, and the concept of consumer equilibrium.
Marginal utility and the demand curve
If marginal utility is expressed in a monetary form, then as more is consumed the expected monetary value of marginal utility will fall, and the rational consumer will be prepared to pay less. In this example, the rational consumer here will pay 15 currency units (p or ¢) for the second unit of chocolate, but only 10 currency units for the third unit of chocolate. The principle of diminishing marginal utility is one way to understand why a demand curve slopes downwards.
While there may be some exceptions, the principle of diminishing marginal utility holds for most goods and services consumed.
Consumer equilibrium
Consumers are said to be in equilibrium when the marginal utility (MU) derived from the last unit of currency is identical for all goods and services spent. The general formula for consumer equilibrium is:
| MU good A | = |
| Price good A |
| MU good B | = |
| Price good B |
| MU good C | = |
| Price good C |
Hence, if a consumer spends all their income on just three goods, Apples (A), Bananas (B) and Carrots (C) they will be 'in equilibrium' when the ratio of marginal utility (MU) to price (P) will be equal - as we can see, the ratio is MU10/P1.
| MU APPLES | = |
| Price APPLES |
| MU BANANAS | = |
| Price BANANAS |
| MU CARROTS | = |
| Price CARROTS |
| MU APPLES 100 | = |
| Price APPLES 10 |
| MU BANANAS 200 | = |
| Price BANANAS 20 |
| MU CARROTS 50 | = |
| Price CARROTS 5 |
If the price of good B (Bananas) rises from its current level of 20 to 40, then the individual is pushed into a disequilibrium state. The obvious way to address this is to 'increase' the level of MU to 400 to re-establish the 10/1 ratio.
| MU APPLES 100 | = |
| Price APPLES 10 |
| MU BANANAS 400 | = |
| Price BANANAS 40 |
| MU CARROTS 50 | = |
| Price CARROTS 5 |
This can only be achieved by consuming less (given the underlying principle of diminishing marginal utility.)
Criticisms of marginal utility theory
In addition to the possibility that the utility from consuming additional units can increase rather than decrease - as with collectibles - diminishing marginal utility seems more able to explain what happens when smaller quantities of identical products are consumed. With much higher value items which are bought infrequently and are not identical - such as a house or a car - diminishing marginal utility seems a far less relevant principle.
Go to alternative theories
Other explanations of the downward sloping demand curve
Demand can also be explained in two other ways.
Income and substitution effect
If budgets are fixed, a lower price means more can be consumed - providing more ‘real’ income. For example, if a consumer has a budget of $2400, then at a price of $6 (at point A) he or she can buy 400 units of good X. If the price falls to $2, then the consumer can purchase 1200 units.
In a similar way, if prices of substitutes to good X are constant, a lower price of good X will encourage consumers to switch to good X.
In most cases, the income and substitution effect combine to create the negative price/demand relationship.
The two effects are called the ‘income effect’ and ‘substitution’ effect.
1 The principle of diminishing marginal utility was first proposed by German economist H. Gossen in 1854, and was later refined and developed by a number of economists including British economist Alfred Marshal.