What is ‘Marginal Utility’
Marginal utility is the additional satisfaction a consumer gains from consuming one more unit of a good or service. Marginal utility is an important economic concept because economists use it to determine how much of an item a consumer will buy. Positive marginal utility is when the consumption of an additional item increases the total utility. Negative marginal utility is when the consumption of an additional item decreases the total utility.
BREAKING DOWN ‘Marginal Utility’
Economists use the concept of marginal utility to measure happiness and pleasure, and how that affects consumer decision making. They have also identified the law of diminishing marginal utility, which means that the first unit of consumption of a good or service has more utility than the next units of consumption.
Example of Marginal Utility
The following example can demonstrate the concept of marginal utility. Imagine that a person has four bottles of water and purchases a fifth bottle of water. Next, imagine that a second person has 50 bottles of water and purchases one more bottle of water. The first person buying the fifth bottle of water will get far more utility from that fifth bottle of water because of its proportion to the total. This fifth bottle increases the total water by 25%. The second person gains far less utility from purchasing a 51st bottle of water, precisely because its proportion to the total is so low. This 51st bottle of water increases the total water by only 2%. As a person purchases more and more of a product, the marginal utility to the buyer gets lower and lower, until it reaches a point where the buyer has zero need for any additional units of the good or service. At that point, the marginal utility of the next unit equals zero.
The idea of marginal utility resulted from 19th-century economists attempting to explain the economic reality of price, which they believed was driven by a product’s utility. This, however, led to a paradox that is commonly known as the “the paradox of water and diamonds,” which is attributed to Adam Smith, author of The Wealth of Nations. The paradox states that water has a value far less than diamonds, even though water is vital to human life and diamonds aren’t. Since marginal utility and marginal cost are used to determine price, the paradox is that the marginal cost of water is much lower than that of diamonds.