Utility Analysis of Demand: Law of Diminishing Marginal Utility

Read this article to learn about the Law of Diminishing Marginal Utility!

Marginal Utility is the utility at the point where the consumer stops further consumption of a commodity.

Statement and Explanation of the Law:

A very important law in consumption relates to the fact that as we go on consuming a commodity, the satisfaction derived from its successive units goes on decreasing.

It is well known that familiarity breeds contempt. The more we have of a commodity, the less we want to have more of it. It is the experience of every consumer that as he goes on consuming a particular commodity, each successive unit of the commodity yields him less and less satisfaction.

In other words, at each step its utility (marginal utility, not total utility) goes on decreasing.

Thus if we are very thirsty and buy a drink to quench our thirst, the drink will yield a great deal of satisfaction at first. After the consumption of the first drink, however, we would not like to have another, because our want has been practically satisfied. This is the case with most of the commodities.

Dr. Marshall states the law thus:

“The additional benefit which a person derives from a given increase of his stock of anything diminishes with the growth of the stock that he has.” In this statement of the law, the word “Additional” is very important. It is only additional (marginal) benefit which decrease and not the total benefit as we shall see in the following table.

The following table relating to an imaginary consumer consuming ‘rasgullas’ illustrates the law:

As the consumer goes on eating ‘rasgullas’, the additional or marginal utility goes on decreasing. The 7th ‘rasgulla’ yields no additional satisfaction and the 8th and 9th have a negative utility (see column 2). Their consumption, instead of giving satisfaction or pleasure, causes dissatisfaction.

If you look at column 3, you will find that the total utility goes on increasing up to a point. It also seems reasonable that the utility of two ‘rasgullas” should be more than that of one, and the total utility of three more than that of two, and so on. But if you look at it more carefully, you will notice that although the total utility does increase, it increases only at a diminishing rate.

(1) No. of Rasgullas	(3) Marginal Utility	Total Utility (2)
1	15	15
2	13	28
3	10	38
4	8	46
5	4	50
6	2	52
7	0	52
8	-2	50
9	-5	45

For example, when our friend consumes the second ‘rasgulla’, the increase in utility is 13; and when he-consumes the third, the total utility increases by 10 only. Column 2 shows the rate at which utility increases. We can see that it increases at a diminishing rate In other words, the marginal utility decreases. (We shall discuss marginal utility more fully presently).

Diagrammatic Representation:

This law can be understood better with the help of the following diagram:

OX and OY are the two axes. Along OX are represented the units of the commodity, ‘rasgullas’, and along OY is measured the marginal utility corre­sponding to the consumption of each unit; UU’ is the utility curve. AB is the utility when one ‘rasgulla’ is taken. CD is the additional utility when two of them are taken: CD is less than AB. The additional utilities of other successive Units are EF, GH. KL and MN.

It can be seen that at each step, the additional utility becomes smaller and smaller. At the seventh unit, there is no addition at all, i.e., the marginal utility is zero, and then it becomes negative, which is re­presented by the shaded area below the axis of X.

We may distinguish between initial utility, total utility, and zero utility and negative utility.

Initial Utility:

It is the utility of the initial or the first unit. In the table given on the previous page, the initial utility is 15.

Total Utility:

Look at column 3 of the table. It gives the total utility at earn step. For example, if you consume one ‘rasgulla’, the total utility is 15; if you consume two, the total utility is 28, and so on.

Zero Utility:

When the consumption of a unit of a commodity makes no addition to the total utility, then it is the point of zero utility. In our table, the total utility, after the 6th unit is consumed, is 52. At the seventh also it is 52. Thus, the seventh ‘rasgulla results’ in no increase whatsoever. This is the point o’ zero utility, it is thus seen that the total utility is maximum when the marginal utility is zero.

Negative Utility:

If the consumption of a commodity is carried to excess, then instead of giving any satisfaction, it may cause dissatisfaction. The utility in such cases is negative. In the table given above the marginal utility of the 8th and the 9th units is negative.

Limitations or Exceptions:

The Law of Diminishing Utility says that as we go on consuming more and more units of a commodity, the utility falls with every successive unit consumed. But this is not always true. We may, therefore, see below what those limitations or exceptions are.

Dissimilar Units:

If the units are not identical, the law will not apply For instance, if the second ‘rasgulla’ is much larger than the first-one, it will yield more satisfaction than the first. The law will apply only if the units are similar.

Very Small Units:

If we are given water by the Spoonful when we .are very thirsty, each successive spoonful will give us more satisfaction. If, however, the unit is the usual tumbler of water, the law starts working at once. In the case of very small units, the law applies at a later stage. At first the marginal utility will therefore, increase instead of decreasing. But ultimately the marginal utility must fall if the consumption is continued, and this is exactly what the law says.

Too Long an Interval:

Suppose you take your morning meal at 10 A.M. and your dinner at 8 P.M. If you eat nothing in between, the dinner will probably yield even greater satisfaction than your breakfast. But if you are asked to take another meal within an hour of the first, the law undoubtedly applies. The law, therefore, applies only when the units of the commodity are taken quickly one after another within a reasonable period of time.

Rare Collections:

The law does not apply in the case of rare collections. If a person has a hobby of collecting rare coins, the larger the number he collects the greater will be his happiness, whereas according to this law it should be less and less.

Abnormal Persons:

When we discuss this law, we assume that we are talking of normal persons. But there are some abnormal people too, e.g., misers. The more money a miser has, the greater is the satisfaction that he derives. The law, therefore, does not apply to abnormal persons like misers, drunkards, musicians, etc., who want more and more of the commodity they are in love with. In such cases, the consumption excites further desire and hence yields greater satisfaction.

Change in another Person’s Stock:

Sometimes utility changes not because change has taken place in the stock of the commodity that a person has of clause a change has taken peace in another person’s stock. Suppose, there are two persons collecting stamps in a town and both are rivals. Suppose further that by an accident the stock of one of them is destroyed. Automatically, the value of the stock of the other person will go up even though there has been no change in his stock.

Changes in Income, Habits and Tastes:

We may add that a change in a consumer’s income, a change in fashion, and a change in other possessions of the consumer also seem to upset the Law of Diminishing Marginal Utility. In such cases, increase in consumption may yield greater and greater satisfaction.

Conclusion:

However, in spite of the above limitations or exceptions, the law has universal application. This is so because it expresses a basic principle of human behaviour.

Does the Law of Diminishing Marginal Utility Apply to Money?

It is sometimes said that the law of diminishing marginal utility could not apply to money. Since money can command an endless variety of commodities and services, there can be no end to a craving for money. More money will be welcomed even if a person has already much of it.

The more he has of it, the more he would like to have it. It would enable him to enjoy not only a large variety of material objects, but would also bring him prestige, power and distinction. Therefore, it is urged that the law of diminishing marginal utility does not apply to money. But a little thought will show that even money is no exception to the law. Every addition to our stock of money, however welcome it may be, has less significance, i.e., we do not attach the same importance to it. As a man grows rich, he becomes careless in spending money. He wastes it on useless luxuries which do him no good.

It only means that a person does not attach the same importance to additional wealth, or that its marginal utility decreases. That is why the-Government taxes the rich people. The richer they are, the higher the taxes they have to pay. The basis of the principle of progressive taxation is the law of diminishing marginal utility. Hence the law of diminishing marginal utility undoubtedly applies to money.

Marginal Utility:

We have been talking about marginal utility without clearly explaining to the student what it means. We shall now explain it fully. We may say roughly that Marginal Utility is the utility at the point where the consumer stops further consumption of a commodity.

That is why it is also called the find utility. But where does a consumer stop? If you are invited by a friend to a feast of ‘rasgullas,’ you will stop when the satiety level is reached, i.e., when you cannot eat any more ‘rasgullas’. In other words, you will stop at the joint of zero utility. This is the case, however, when you have not got to pay anything for the ‘rasgullas’.

One does not, however, receive invitation to a least every day. A consumer has ordinarily to pay for what he wants to take. In that case, he will naturally weigh in his mind the price that he has to pay and the pleasure that he gets. So long as the utility is greater than the price, he will go on consuming. But as he goes on, the utility steadily decreases. Sooner or later, a point will be reached when the utility and price balance each other.

Obviously, he will stop eating at this point, for if he goes further, the utility will be less than the price and he will be closer. This is the point of marginal utility. At this point, the benefit received is just equal to the price that has been paid.

Properly speaking, Marginal Utility may be defined as the addition to the total utility by the consumption of the last unit considered just worthwhile.

If our consumer stops after consuming the 5th “rasgulla,’ the marginal utility is 4. Where he actually stops will depend on the price of the commodity. Because if the price falls, he will consume more and the marginal utility will go down, and vice versa.

We may here warn the student that it is wrong to say that the marginal utility in this case is (he utility of the 5th ‘ragulla.’ All the ‘rasgullas’ arc alike, they cannot have different utilities. But because a ‘rasgulla’ happens to be taken in the 5th place, its utility is less than that of each of those taken previously. Hence, it is best to say that the marginal utility is what is added to the previous total when the unit, which is considered just worthwhile purchasing, is consumed.

Margin is not fixed:

It moves back and forth. If the price rises, we shall stop earlier. But if it falls, we shall purchase more. Thus, the margin is shifted as the price of the commodity changes.

The relation between price and marginal utility is discussed below:

Marginal Utility and Price:

Suppose each unit of marginal utility is worth ten paisa. This would mean that the utility of the first ‘rasgulla’ is equal to fifteen ten paisa. Suppose ‘rasgullas’ are being sold at 80 paisa each. Then we shall stop buying at the 4th because at this point marginal utility and price have been equalised. At the third, the utility is worth Re. 1, whereas the price is 80 paisa. Hence we are tempted to buy the next, i.e., the 4th, but no more.

At this point, the price is 80 paisa and the utility is also worth 80 paisa. The two coincide. If the price of a ‘rasgulla’ were to fall to twenty paisa each, we shall buy even the 6th, for it is at that point that the marginal utility and the price will be equal. This is how the margin will shift with each change in price and the shifting will continue until price and marginal utilityhave been equalized.

That is why it is said that price measures marginal utility. When we pay a certain price for a commodity, it can be taken for granted that we think that the satisfaction is at least equal to the price paid. Hence we say that price measures the marginal utility or that marginal utility indicates the price.

Marginal Utility does not determine Price. The relation between marginal utility and price may be carefully understood. They move together. If the price goes up, the marginal utility also goes up because now we buy less, and vice versa. The two coincide. But it is wrong to say that the marginal utility determines or governs price. It simply indicates it Instead of marginal utility determining price both marginal utility and price are governed by demand and supply.

Importance of the Law of Diminishing Marginal Utility:

The law of diminishing marginal utility expresses a basic principle of a consumer’s behaviour. And the law is of immense use to a person in almost every walk of life.

In Taxation:

We have seen that the law is applicable in the sphere of taxation a man’s income increases; he is more heavily taxed, for the utility of money to a rich person is less than that to a poor person. The principle of progressive taxation is based on this law.

In Determining Prices:

The law also applies to the determination of market price increase in the stock of a commodity brings a person less satisfaction; therefore he can be induced to buy more only if the price is lowered. Thus, great the supply, the lower should be the price to clear it, and vice versa.

In Support of Socialism:

Socialists, take their stand on this law when they advocate a more equal distribution of Wealth. They argue that excessive wealth in the hands of the rich is not so useful from the social point of view, as it would be if the excess of wealth is transferred the poor. In the hands of the poor, it will satisfy more urgent needs. It is due to the law of diminishing marginal uti­lity that, beyond a certain point, wealth will have less utility for a rich man. If it is transferred to the poor, it will have much greater utility.

In Household Expenditure:

The law of diminishing marginal utility regulates our daily expenditure. We know that as we go on buying more of a commodity, its marginal utility falls. Having only a limited amount of money at our disposal,’ we cannot waste it unnecessarily on a large quantity of any one commodity. We, therefore, stop purchasing it at a point where the utility of money spent is equal to the utility of the last unit of the commodity purchased. We spend the rest of our money on some other commodities.

Basis of Some of Economic Laws:

Several very important laws and concepts of Economics arc based on the law of diminishing marginal utility, e.g., the Law of Demand, the concept of Consumer’s surplus, the concept of Elasticity of demand, the Law of Substitution. All these laws and concepts have ultimately been derived from the Law of diminishing Marginal Utility.