ECON100 CONCEPT OF THE DAY: Diminishing Marginal Utility
As part of our dual mandate to rebrand the dismal science’s moniker into the ‘decision’ making science as well as to lower the barrier to understand and access economic concepts without a formal economics degree, we’re rolling out a definition of the day (or week) to further these goals. Today’s concept of the day (or week) is: diminishing marginal utility.
Exactly WTF is diminishing marginal utility?
Diminishing marginal utility is fancy wording to describe a concept representing a phenomenon you probably observe quite often in the everyday world. If not, we’re about to change that by removing the shroud covering this concept. In general, as one begins to consume or accumulate more of a good or an item, each additional item or good becomes less useful or less valuable as it is added to the collection. Check out this delicious slice of Americana: deep-fried Oreos. If you’re lucky (we certainly were) you will experience something similar at your local county fair, or like we did, at a seasonal Pumpkin Patch we visited the other day. The first few deep-fried cookies are going to deliver a euphoria any hard core sweet tooth sugar addict can attest to. This makes the first deep-fried delicacy very valuable. Afterwards however, consumption of the next few cookies, while very delicious, will fail to reach that level of satisfaction despite being part of the same batch. On close inspection you can see a pattern emerging. Eating additional (marginal) deep-fried cookies will not match the same level of satisfaction (utility) as the ones previously consumed. If we were to construct a graphical representation it would look like this.
As mentioned earlier, going from zero to one deep fried Oreo cookies is amazing. It’s the cookie we value the most and we’ll pay top dollar for that experience (however we could also measure utility in other ways). Looking at the graph you can also see that Oreo #2 still delivers a . Diminishing marginal utility could also in theory become negative if, for example, by eating an 11th (or 12th) deep fried Oreo cookie you gave yourself an upset stomach and became sick. This unfortunate experience would not provide you with additional satisfaction and would lower your overall satisfaction.
Why should you care about diminishing marginal utility?
Because understanding diminishing marginal utility unlocks another way to understand the demand curve and the display of the relationship between an item’s price and the quantity demanded for that item. As you might expect, there is diminishing marginal utility for the consumption of things both society and individuals view as positive such as exercise, education, leisure, even water. Notice the table below.
OK, so what does diminishing marginal utility mean for you?
Once diminishing marginal utility is no longer a mystery, you’ll see how your everyday observations add empirical (observable) support to this concept. This concept ties in very closely with marginal analysis, which involves forming a decisions by considering the cost of an additional unit against the benefit of that unit. With those tools at your disposal, you’ll see why an annual pass to a theme park is less expensive than the equivalent amount of single day, or even weekly pass prices. The same goes for Caribbean cruises, smoothies at the local juice bar, and soda at the beverage fountains inside of your local gas station. Larger sized containers (like water) are slightly more expensive overall, but cheaper per ounce. Now you know why.
The second takeaway is making better decisions. Behavioral economics is a rapidly growing branch of economics, a modern take upon a foundation build by classical economist Adam Smith. Rational choice theory involves choosing something (or a combination of things) by considering the cost of an additional unit against the benefit of that unit. The process comes to an end when the individual reaches a point (the type you can plot on a graph) which provides the highest level of benefit (utility) that can be reached given (1) the individual’s constraints under scarcity, normally some kind of budget curve and (2) the individual’s preferences. If you’ve made it through the entire post congratulations! Here’s the takeaway of this entire concept: stop the activity when the marginal utility/benefit from that specific activity exceeds the marginal cost of that activity. This theory formed the basis of what Smith commented in his classic An Inquiry into the Nature and Causes of the Wealth of Nations. Whether that is eating one or one dozen deep fried Oreos, I can’t tell you where that point is, dear economist. Only you know.
REFRENCES
Smith, Adam. The Wealth of Nations. Urbana, Illinois: Retrieved from Project Gutenberg www.gutenberg.org/ebooks/3300.