Saturday, December 11, 2010

The Theory Of Diminishing Marginal Utility

Dec 10, 2010 Stuart McClelland

Marginal utility of an eco textbook? Zero : ) - genericface

Marginal utility of an eco textbook? Zero : ) - genericface

If you're reading this right now, you are either curious about economics or you have an exam tomorrow, and are cramming for it. I've been there myself too many times to count, so will try to explain it as clearly as possible. The truth is, "The theory of diminishing marginal utility" is really easy to understand, but the big words often throw people off.

So, what exactly does each word mean?1. Diminishing = Dropping or falling.

2. Marginal = The next/ additional item

3. Utility = satisfaction gained from consumption/ how happy consuming something makes you.

Altogether then, we can simplify "The theory of diminishing marginal utility" to "Falling satisfaction as each next item is consumed".

Here is an easy example to explain the theoryYou are really really hungry. You could eat an entire chicken right now, you are so starving. Someone gives you a hamburger. Imagine how happy this makes you. It brings a lot of satisfaction and reduces your hunger greatly.

The hamburger was not enough though. You are still quite hungry, so the person gives you another hamburger. Although it is exactly the same as the first one and you enjoy it, you notice that you didn't like it quite as much as the last burger. Since you were more full when you ate it, you got less satisfaction from the second burger.

By burger number 3, you're pretty full, and you get even less joy from this one. If you keep eating beyond this point, you may begin to feel sick, and so the total satisfaction or utility from burger number 4 is likely to be zero.

And that is basically the theory of diminishing marginal utility: The more you consume of a good, the less utility each next one brings you. Remember that this does not only apply to food, but all consumption goods and services. Say you have a bed but no pillows. The first pillow you acquire is very useful to you, but by number 5 or 6, you're likely not to care very much if you get another one, because it won't make you any better off.

So how does Diminishing marginal utility relate to the Demand Curve?If you get this question in an exam or something similar, like "why does the demand curve slope downwards", there are 4 points to remember for a perfect answer:

1. Define the theory : "The Theory Of Diminishing Marginal Utility states that as a consumer consumes more of a good or service, the utility or satisfaction they gain from each next unit of that good/service becomes less and less.

2. Throw in an example. E.g. The pillow example/the hamburger example above.

3. Explain that people are prepared to pay money for utility. E.g. When you buy a hamburger, you are buying it to bring you satisfaction in someway. The price you are prepared to pay for it must be less than or equal to how much utility it brings you (P=MU). If the price of the burger is greater than the satisfaction it brings you (P>MU), you will not think it is worth it,, and therefore will not buy it..

4. Under the law of diminishing marginal utility, as quantity demanded goes up (i.e. as you consume more of a good), utility falls. We also know that P=MU.

Therefore, as quantity demanded goes up, and MU is falling, P must also be falling: The more hamburgers you eat, the less satisfaction each next one brings you, and therefore the less you will be prepared to pay for it.

This conclusion basically linked the theory of diminishing marginal utility to the demand curve. It used the theory to explain the law of demand : as quantity demanded goes up, price falls. The above four points should be sufficient to answer any question on this topic. It is the full story up to about 1st year university papers. Watch out for the way the question is worded though, because you may need to adapt your answer a little to focus on what it is asking. If you have any questions or comments, please feel free to leave them at the bottom of this article, and I will try to answer them for you as soon as possible.

Copyright Stuart McClelland. Contact the author to obtain permission for republication.

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