The law of diminishing marginal utility states that marginal utility decreases when you consume one more good. Marginal utility is a measure of the extra satisfaction (benefit or utility) you get when you add another consumption of goods or services.
Say, you buy a second glass of Starbuck. This law states your satisfaction from the second glass is less than the first glass. Likewise, when you buy a third glass. It gives lower than the second or first glass.
The law proposed by Carl Menger (1840-1921) is essential to explain some economic concepts, especially the reasons behind the demand curve’s negative slope.
What is utility
In economics, utility represents the satisfaction or benefit that you get when consuming goods or services. That is a subjective concept. For example, you might have high satisfaction with the iPhone. But, not to your friends or colleagues.
Furthermore, satisfaction is also an ordinal concept. I mean, you cannot compare your satisfaction with the satisfaction of others. Say, you are asked to rank your satisfaction with the iPhone, from 1-10. You then give a value of 10. Your friend is also asked to rank for the same item, and he gives a value of 5. Your satisfaction is higher than your friend’s, but that does not mean your satisfaction is twice your friends’ satisfaction.
Why the law of diminishing marginal utility matters
This law explains several important phenomena in the economy. It becomes a critical concept to determine consumer preferences for the time and value of goods. Following are the two main applications of this law:
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- Diminishing marginal utility of money
- Diminishing marginal utility of consumption
What is diminishing marginal utility of money
An increase in the supply of goods reduces the exchange value of the currency. Additional units of money, indeed, can be used to fulfill further objects, however, those objects are not too urgent than the previous goals.
Say, you have a little money so you can’t buy the house and various items you want. You then get bonus money so you can buy them. Such satisfaction is, of course, significant.
Let’s say you have fulfilled all the essential needs. When you get the second bonus money, your extra benefit or happiness may not be as significant as the first.
That is why an additional supply of money will only reduce its value. And, monetary policy to increase the money supply will only reduce the exchange rate (purchasing power) of money. Such a policy only benefits the first recipient of new money at the expense of the recipient after that.
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What is diminishing marginal utility of consumption
Extra satisfaction (marginal utility) declines as more goods consumed. When you add one more item for consumption, the additional satisfaction you get will be lower than the previous one.
Let’s take a simple analogy.
You are very thirsty and go to the store to buy a bottle of mineral water. After you drink, your thirst starts to subside. Then, you buy a second bottle to reduce it again.
The extra satisfaction you get from the second bottle will be lower than the first one because your thirst has decreased. Likewise, if you buy a third bottle, it only gives lower satisfaction than the second.
How the law of diminishing marginal utility explains the demand curve
The demand curve is downward sloping (has a negative slope). That shows when the price goes up, the quantity demanded goes down. And conversely, when prices fall, the quantity demanded increases. Then, how does this relate to diminishing marginal utility law?
Let’s take back the example of the previous mineral bottle. Let’s say the price of the first bottle of mineral water is Rp1,000. You are willing to pay because you get equal satisfaction.
For the second bottle, if you have to buy, you will be willing to pay a lower price. The second bottle gives less satisfaction than the first bottle. Likewise, you will be willing to buy a third bottle if it is lower than the second bottle. The reason remains the same, you get less satisfaction.
So, as more goods you consume, your additional satisfaction (marginal utility) will decrease. If we draw it, it will form a marginal utility curve. The X-axis represents the quantity you consume. The Y-axis represents the satisfaction you get.
If you quantify that satisfaction into the price that you are willing and able to pay, then the marginal utility curve will be the same as the demand curve.
What are the assumptions and exceptions for diminishing marginal utility
There are several assumptions so that the marginal utility of consumption law applies, including:
- Quality doesn’t change. If the quality of goods increases or decreases, the law may not be proven right. If you get second mineral water of better quality, you may still be willing to pay a high price.
- Sequential consumption. That means you immediately buy the second bottle of mineral water at the same store at that moment. If you purchase it elsewhere at different hours, the marginal utility will naturally be different.
- Your psychology remains the same. When you don’t like the taste of the drink you buy, you might switch. The concept of diminishing marginal utility is inapplicable.