In mainstream economics, marginal utility refers to the change in utility (pleasure or satisfaction resulting from the consumption) of one unit of a good or service. Marginal utility can be positive, negative, or zero. Negative marginal utility implies that every consumed additional unit of a commodity causes more harm than good, leading to a decrease in overall utility. In contrast, positive marginal utility indicates that every additional unit consumed increases overall utility.
In the context of cardinal utility, liberal economists postulate a law of diminishing marginal utility. This law states that the first unit of consumption of a good or service yields more satisfaction or utility than the subsequent units, and there is a continuing reduction in satisfaction or utility for greater amounts. As consumption increases, the additional satisfaction or utility gained from each additional unit consumed falls, a concept known as diminishing marginal utility. This idea is used by economics to determine the optimal quantity of a good or service that a consumer is willing to purchase.
Marginality In the study of economics, the term marginal refers to a small change, starting from some baseline level. Philip Wicksteed explained the term as follows: Marginal considerations are considerations which concern a slight increase or diminution of the stock of anything which we possess or are considering.Wicksteed, Philip Henry; The Common Sense of Political Economy (1910), Bk I Ch 2 and elsewhere. Another way to think of the term marginal is the cost or benefit of the next unit used or consumed, for example the benefit that you might get from consuming a piece of chocolate. The key to understanding marginality is through marginal analysis. Marginal analysis examines the additional benefits of an activity compared to additional costs sustained by that same activity. In practice, companies use marginal analysis to assist them in maximizing their potential profits and often used when making decisions about expanding or reducing production.
Utility Utility is an economic concept that refers to the level of satisfaction or benefit that individuals derive from consuming a particular good or service, which is quantified using units known as utils (derived from the Spanish word for useful). However, determining the exact level of utility that a consumer experiences can be a challenging and abstract task. To overcome this challenge, economists rely on the consent of revealed preferences, where they observe the choices made by consumers and use this information to rank consumption options from the least preferred to the most desirable.
Initially, the term utility equated usefulness with the production of pleasure and avoidance of pain by moral philosophers, Jeremy Bentham and John Stuart Mill.Bentham, Jeremy. Introduction to the Principles of Morals and Legislation, Chapter I §I–III. In line with this philosophy, the concept of utility was defined as "the feelings of pleasure and pain"Jevons, William Stanley; "Brief Account of a General Mathematical Theory of Political Economy", Journal of the Royal Statistical Society v29 (June 1866) §2. and further as a "quantity of feeling".Jevons, William Stanley; Brief Account of a General Mathematical Theory of Political Economy, Journal of the Royal Statistical Society v29 (June 1866) §4.
Contemporary mainstream economic theory frequently defers metaphysical questions, and merely notes or assumes that preference structures conforming to certain rules can be usefully proxied by associating goods, services, or their uses with quantities, and defines "utility" as such a quantification.Kreps, David Marc; A Course in Microeconomic Theory, Chapter two: The theory of consumer choice and demand, Utility representations.
In any standard framework, the same object may have different marginal utilities for different people, reflecting different preferences or individual circumstances.Davenport, Herbert Joseph; The Economics of Enterprise (1913) Ch VII, pp. 86–87.
Law of diminishing marginal utility The law states that as the amount consumed of a commodity increases, other things being equal, the utility derived by the consumer from the additional units, i.e., marginal utility, goes on decreasing. For example, three pieces of candy are better than two pieces, but the twentieth piece does not add much to the experience beyond the nineteenth (and could even make it worse). This principle is so well established that economists call it the "law of diminishing marginal utility" and it is reflected in the concave shape of most utility functions. This concept is fundamental to understanding a variety of economic phenomena, such as time preference and the value of goods.
Assumptions -
All the units of a commodity must be identical, i.e., same in all respects - in size, colour, design, quality, etc. The unit of the good must be standard, e.g., a bottle of cold drink, a pair of shoes, a full mango, etc. The units must not be too small or too large. There should be no change in taste of the consumer during the process of consumption. The utility is measurable. The consumer is rational while taking consumption decisions. There must be a continuity in consumption and if a break in the continuity is necessary, the time interval between the consumption of two units must be short. There should be no change in the price of substitute goods.
Modern economics employs ordinal utility to model decision-making under certainty at a specific point in time. In this approach, the number assignment to an individual's utility for a particular situation hold no significance on their own. Rather, the significance lies in the comparison between two different circumstances and which one holds a higher utility. With ordinal utility, a person's preferences do not have a unique marginal utility, making the concept of diminishing marginal utility irrelevant. On the other hand, diminishing marginal utility is a significant concept in cardinal utility, which is used to analyse intertemporal choice, choice under uncertainty, and social welfare in modern economic theory.
The law of diminishing marginal utility is that subjective value changes most dynamically near the zero points and quickly levels off as gains (or losses) accumulate. And it is reflected in the concave shape of most subjective utility functions.
Given a concave relationship between objective gains (x-axis) and subjective value (y-axis), each one-unit gain produces a smaller increase in subjective value than the previous gain of an equal unit. The marginal utility, or the change in subjective value above the existing level, diminishes as gains increase.
As the rate of commodity acquisition increases, the marginal utility decreases. If commodity consumption continues to rise, the marginal utility will eventually reach zero, and the total utility will be at its maximum. Beyond that point, any further increase in commodity consumption leads to negative marginal utility, which represents dissatisfaction. For example, beyond some point, further doses of antibiotics would kill no pathogens at all and might even become harmful to the body. In some circumstances, however, the marginal utility of a good or service might be increasing, as with, for example, dosages of antibiotics, where having too few pills would leave bacteria with greater resistance, but a full supply could affect a cure.
Diminishing marginal utility is traditionally a microeconomic concept and often holds for an individual, however there are instances where marginal utility can increase on a macroeconomic level. For instance, offering a service may only be feasible if it is accessible to the majority or all of the population. At the point where this becomes a reality, the marginal utility of the raw material required to provide the service will increase significantly.
Marginalist theory Marginalism is an economic theory and method of analysis that suggests that individuals make economic decisions by weighing the benefits of consuming an additional unit of a good or service against the cost of acquiring it. In other words, value is determined by the additional utility of satisfaction provided by each extra unit consumed.
Market price and diminishing marginal utility If a person has a good or service that has less value to them compared to another good or service they could trade it for, it would be beneficial for them to make that trade. The marginal gains or losses from further trades will vary as items are exchanged. If the marginal utility of one item is decreasing while the other is not increasing, then the individual will demand a greater amount of the item they're acquiring in comparison to the one they're giving up. However, if the two items complement each other, then the exchange ratios might remain constant.Mc Culloch, James Huston; "The Austrian Theory of the Marginal Use and of Ordinal Marginal Utility", Zeitschrift für Nationalökonomie 37 (1977) #3&4 (September). In situations where traders can improve their position by offering trades that are more favorable to complementary traders, they are likely to do so.
In an economy that uses money, the marginal utility of a given quantity of money is equivalent to the marginal utility of the best good or service that could be purchased with that money. This concept is helpful for explaining the principles of supply and demand, and is essential aspects of models of imperfect competition.
Paradox of water and diamonds
The "paradox of water and diamonds" is most commonly associated with Adam Smith,Smith, Adam; An Inquiry into the Nature and Causes of the Wealth of Nations (1776) Chapter IV. "Of the Origin and Use of Money" though it was recognized by earlier thinkers. The apparent contradiction lies in the fact that water possesses a lower economic value than diamonds, even though water is far more vital to human existence. Smith suggested that there was an irrational divide between the 'use value' of something and the 'exchange value'. The things which have the greatest value in use frequently have little or no value in exchange; and likewise, things which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarcely anything. A diamond has hardly any practical value in use, but a great quantity of other goods may be purchased in exchange for it.
Price is determined by both marginal utility and marginal cost, and here is the key to the apparent paradox. The marginal cost of water is lower than the marginal cost of diamonds. That is not to say that the price of any good or service is simply a function of the marginal utility that it has for any one individual or for some ostensibly typical individual. Rather, 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 constrains by these marginal utilities.
Marginalism limitations Marginalism has many limitations and economic theories. Some scholars, such as Warren J. Samuels, have raised concerns that individuals may not always behave as portrayed in marginalist theories, highlighting complexities in human decision-making that go beyond simple optimizing behavior. Additionally, utility is difficult to quantify precisely, as it varies significantly from person to person and may not be stable over time. Another limitation lies in measuring the marginal change: while monetary values can be straightforward to track, gauging the utility derived from non-monetary goods like food is more challenging, as individual preferences and the wide range of alternatives complicate accuracy.
Quantified marginal utility