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Tuesday, June 30, 2009

Marginal Utility

  • Like supply and demand as well as elasticity, concept of utility is another of basics in economics.
  • Utility is not a concrete concept.
  • It is an abstract concept.
  • Utility is generally understood as the satisfaction or benefit that an individual gets from consumption of goods or services of a particular quantity.
  • Thus, if someone keeps consuming more of an item, it can be inferred that the item has high utility for him.

Total Utility and Marginal Utility

  • The cumulative total of the satisfaction or benefit a person gets from consumption of goods and services of a particular quantity is called the total utility.
  • Therefore, the total utility is related to an individual's level of consumption. More the consumption, more the utility.
  • For example, an individual consumes x1 units of item A and he derives utility u1, then the total utility is u1 from consumption level x1. Now he additionally consumes x2 units of that item A and from consuming x2 units, he derives an additional utility u2. Then, the total utility he will derive from consuming quantity x1+x2 will be u1+u2 of item A.
  • In the above mentioned example, the incremental utility u2 of item A from the incremental consumption x2 is called item A's marginal utility. Therefore, marginal utility is defined as the additional degree of utility (satisfaction or benefit) obtained from each extra unit of consumption.
  • Normally, the total utility increases with consumption of more units of an item but the marginal utility normally decreases with each additional increment in the consumption of that item.
  • This phenomenon of getting less incremental utility from each incremental consumption is formalized as the law of diminishing marginal utility.

Law of Diminishing Marginal Utility

  • There is always a limit to getting satisfaction or pleasure or utility. This limit is the threshold level. Once you cross this threshold level, the satisfaction or pleasure or utility starts diminishing; you now do not enjoy it to the same degree.
  • The utility now increases at a slower rate than the rate at which it was increasing for the consumption up to the threshold level. Therefore, the marginal utility increases at a slower rate and so, also the total utility for each additional unit of consumption beyond the threshold level.
  • Therefore, the law of diminishing marginal utility states that as an individual increases consumption of an item- while keeping consumption of other items constant- the marginal utility that the individual derives from consuming each additional unit of that item decreases.
  • Example: The first ice cream cone you eat, it gives you lots of satisfaction and pleasure. You feel like eating more. So you eat one more and you feel the same level of satisfaction and pleasure. That makes you to eat one more but as you eat this additional one, you realize that the degree of satisfaction and pleasure now you are getting from the third ice cream cone is not exactly the same as you got from the first and even the second one. Suppose, on insistence of your friend, you venture to eat the fourth one too, you find that this yet additional ice cream cone is giving you lots less satisfaction and pleasure that what even the third one gave. Thus with each additional ice cream cone, the quantum of each additional satisfaction and pleasure is diminishing. Ultimately a stage may come when you will refuse to eat any further ice cream cone; it's utility may become zero for you.

No of ice cream cones............... Marginal utility............... Total Utility

first 2 cones...................................2o.............................2o

3 cones.........................................5..............................25

4 cones.........................................1..............................26

  • Realizing this phenomenon of diminishing utility, the sellers try to sell you more (even beyond your threshold level of utility) even by giving discounts.

Maximization of Total Utility

  • Consumer does not use only one item. As per law of diminishing marginal utility, he will find extremely low utility of one item if he start purchasing or consuming only that item and that too in large quantities.
  • Consumer needs other items too.
  • From each item he consumes, he derives some utility of each of them.
  • With his limited resources, the consumer will like to buy such quantities of each item of his need which will give him the highest utility of each item as well as the total highest utility of the sum of individual item's utilities.

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