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Marginal Utility

The extra benefit derived from consuming one more unit of a specific good or service

What is Marginal Utility?

Marginal utility refers to the additional benefit derived from consuming one more unit of a specific good or service. Consuming units can result in positive, negative, or zero marginal utility. Utility is not constant, and for every additional unit consumed, often the consumer experiences what economists refer to as the diminishing marginal utility, where each additional unit adds less and less marginal utility.

 

Marginal Utility

 

Summary

  • Marginal utility is the extra benefit derived from consuming one more unit of a specific good or service.
  • The main types of marginal utility include positive marginal utility, zero marginal utility, and negative marginal utility.
  • Consumers often experience higher marginal utility when marginal cost is lower.

 

Understanding Marginal Utility

While explaining the “Paradox of Diamond-Water,” economist Carl Menger contributed to the emergence of the marginal utility revolution. He used the ordinal utility theory to reason how consumers use preference to place a higher value of one unit of consumption over the other.

In such a case, a consumption unit that is deemed to derive more utility is given more preference and more value over the subsequent ones. Over time, the perceived value will add little to the satisfaction leading to the consumer experiencing negative or zero marginal utility.

To quantify satisfaction, economists used cardinal utility theory to explain how to measure utility. It is measured using units called utils. The first consumed unit is given higher marginal utils; the subsequent ones are given less and less. In this context, in either of the two utility theories, the effort is to try to understand the consumer willingness to consume an extra unit of a good or service. Therefore, economists use marginal utility as a tool to understand and explain this behavior.

 

Practical Example

Assume Jane will be celebrating her 24th birthday. She is eager to receive presents from her friends. They all know she loves chocolate. Therefore, on her birthday, all ten of her friends buy her a bar of chocolate each. Excited as she is, she grabs her first chocolate in a hurry and gives it several bites. Let’s say a total of five bites.

From the marginal utility argument, the first chocolate bar Jane received increased her excitement to the maximum. As each chocolate bar is received, she experiences less and less excitement. It’s a similar effect with the bites. The first bite was sweet and she experienced an endorphin rush. However, by the fifth bite, her excitement is no longer the same as she becomes more accustomed to the taste. Eventually, she might only eat one or two bars while the rest are reserved for another day.

 

Three Common Types of Marginal Utility Explained By Example

Continuing with the example above, here are the three types of marginal utilities:

 

Positive Marginal Utility

It is the excitement (utility) gained as additional units of consumption increase. For the case of Jane, the more she received chocolate bars, the more she felt loved and appreciated. Each extra bar brought her positive marginal utility.

 

Zero Marginal Utility

Occurs when a consumer becomes indifferent to consuming the next additional unit. In the case of Jane, all her ten friends brought her chocolate, supposing each gift was presented in a subsequent order. Also, none of the friends brought her a different type of present. Economists argue that the tenth bar of chocolate will not be as exciting as her first, and may reach a point where she no longer appreciates the gifts. At this point, her marginal utility will have reached zero.

 

Negative Marginal Utility

It occurs when an extra unit of consumption causes harm or damage. In Jane’s case, eating more than two chocolate bars may cause her to get sick and kill her desire to eat any more chocolates.

 

Practical Application of Marginal Utility

The four common applications of marginal utility include:

 

Progressive Taxation System

Marginal utility is used to justify the progressive taxation system. The idea that those with high income pay more than those with a lower income is a rational marginal utility deduction. A competing flat tax rate system is seen as oppressive to the lower-income earners as marginal cost is higher than the marginal utility.

 

Consumer Behavior in Consumption of Goods

Consumers will seek out products that they deem will give them higher marginal utility. An informed company will spot the trend in the market and offer more utility.

 

Executive Decision in Pricing of Goods

Assume a restaurant sells two types of pizzas: Margherita Pizza and Mexican Green Pizza. Over time, the management learns its customers demonstrate a greater preference for Mexican Green Pizza. Using the marginal utility deduction, the restaurant should price Mexican Green Pizza higher.

 

Product Innovation

Motor vehicle manufacturers understand well how to apply the law of marginal utility. For example, if a given vehicle model performs better in the market, the manufacturer usually adds extra features to position them better in pricing and to sustain sales volume.

 

More Resources

CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

  • Consumer Surplus
  • Expected Utility
  • Indifference Curve
  • Marginal Cost

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