Marginal Utility

In economics, the marginal utility of a good or service is “the perceived value from an increase in the consumption of that good or service”. In other words, how much benefit do you get from using or consuming one more.  The concept of marginal utility grew out of attempts by economists to explain how individuals determine price. The term “marginal utility” is credited to the Austrian economist Friedrich von Wieser which was a translation of Wieser’s term “Grenznutzen” (border-use).

For years economists knew that there was some sort of interrelationship between utility and rarity that affects economic decisions, but were at odds to quantify it. In opposition to what Karl Marx might have believed, Richard Whately, wrote in Introductory Lectures on Political Economy (1832) “It is not that pearls fetch a high price because men have dived for them; but on the contrary, men dive for them because they fetch a high price.”

The benefit or “utility” is often equated with usefulness but the definition can be broadened to the production of pleasure and avoidance of pain. As we can see with the pearls example there is more to utility than just usefulness although pearls can be used to make necklaces; what are necklaces used for?  It could be beauty or simply aesthetics as in the case of a painting (i.e. the production of pleasure). The term “marginal” often refers to the next unit used, derived from the idea of the unit on the margin or edge.

The marginal decision rule states that a good or service will be consumed at a quantity at which the “marginal utility” is equal to the “marginal cost” (i.e. the cost of producing one more unit of a good). In other words, you keep on consuming as long as the benefit is less than or equal to the cost of obtaining it. So the last item consumed is strictly break-even while in earlier items the benefit would exceed the cost. Marginal utility is an underlying factor in all trade, if an individual possesses a good or service whose marginal utility to him is less than that of some other good or service for which he could trade it, then it is in his best interest to effect that trade. Conversely, the person he is trading with will have the opposite set of priorities. If any trader can better his position by offering a trade more favorable to complementary traders, then he will do so.

This leads economists to try to quantify the benefit or utility in order to evaluate whether the benefit does in fact exceed the cost. But in many cases quantifying the benefit received is simply a feeling. Is the value of a steak dinner worth $12.95 or $89.95 well that depends on which restaurant you are eating it at. The Austrian school of economic thought generally attributes value to the satisfaction of needs, and sometimes rejects even the possibility of quantification. It has been argued that the Austrian framework makes it possible to consider rational preferences that would otherwise be excluded.

Economists sometimes speak of a law of diminishing marginal utility also known as Gossen’s First Law, meaning that you derive less value the more you consume. The law of diminishing marginal utility is similar to the law of diminishing returns which states that as the amount of one factor of production increases as all other factors of production are held the same, the marginal return (extra output gained by adding an extra unit) decreases. The use of fertilizer is an excellent example of diminishing returns. Initially the application of fertilizer improves crop production but at some point adding more fertilizer provides less benefit per unit of fertilizer and eventually adding more fertilizer can reduce the yield or even kill the plant.

The Paradox of Water and Diamonds

The “paradox of water and diamonds”, most commonly associated with Adam Smith is the apparent contradiction that water possesses a value far lower than diamonds, even though water is far more vital to a human being. Price is determined by both marginal utility and marginal cost, and here the key to the “paradox” is that the marginal cost of water is far lower than that of diamonds. Individuals are willing to trade based upon the respective marginal utilities of the goods that they have or desire (with these marginal utilities being distinct for each potential trader), and prices thus develop constrained by these marginal utilities.

This graph shows the marginal utility of diamonds and water as a function of the amount consumed. As a person consumes (buys) more and more diamonds or water each additional unit of diamonds or water results in a lower marginal utility. This is phenomenon is known as the law of diminishing marginal utility. In 1871, Austrian economist Carl Menger published Principles of Economics in which he took special pains to explain why individuals should be expected to rank possible uses and then to use marginal utility to decide amongst trade-offs.

The graph makes it clear that a person derives much more utility from the first units of water than the first units of diamonds (the first units of water keep the person from dehydrating and thus have a much higher marginal utility). However, at some point the person can consume no more water and so the marginal utility falls to zero. Similarly, at some point you can’t wear any more diamond necklaces and earrings so another one has very little value to you.

The Law of Declining Marginal Utility

by Bill Bonner

Almost everything in nature is subject to the law of declining marginal utility. You get one ice cream sundae for dessert. You like it. You order another and probably get less satisfaction from it. The third begins to make you sick. Likewise, by the 1970s, mature economies – the US, Europe and Japan – were already reaching the point of declining marginal utility in energy. They still liked it. But they weren’t getting the sugar high that it used to give them.

It was fossil fuels that gave the developed economies such a big leap forward in the postwar years. Energy use went up; GDP growth rose too. But then, in the 1980s and 1990s, energy use began to level off and even fall – especially in Europe.

GDP growth rates declined as well. Because the returns on energy investments no longer paid off the way they had before. People already had automobiles, trucks, machines, appliances – all the paraphernalia of modern life. They could get little real growth by adding more.

See Also:

• Financial Jargon – Investment Terminology for Beginners
• Misery Index
• What is Deflation?
• Its Weight in Gold: The Real Prices of Things

Principles of Economics by Carl Menger	Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics	The Road to Serfdom by F. A. Hayek	The Theory of Money and Credit

Bill Bonner’s commentary is reprinted by permission and is an excerpt from The End of the World As We Know It

This article uses material from the Wikipedia article Marginal Utility, which is released under the Creative Commons Attribution-Share-Alike License 3.0.