What It Means
Marginal utility is a concept used by economists to explain how consumer desire plays a role in determining prices for specific products and services. In economics the term utility refers to the amount of satisfaction a consumer receives from a specific good or service. From an economic standpoint, the usefulness of an object has no role in determining its utility; rather, utility is a measure of how much the consumer wants the object.
A consumer’s desire for a product usually changes as he or she obtains more of it. For example, while a very thirsty consumer will derive a high level of satisfaction from one bottle of water, he or she will probably gain less satisfaction from a second bottle and even less from a third. Each additional unit thus provides less utility.
The term marginal utility, then, is used to describe the amount of satisfaction a consumer receives from each additional unit of a good that he or she acquires. It is called marginal because it applies to the margin (or difference) between units. In the case of the thirsty consumer, the water is said to have a declining marginal utility because each additional unit acquired is less desirable than the one before it. A good is considered to have constant marginal utility if the consumer continues to gain a similar amount of satisfaction from each additional unit he or she purchases. In most cases, a product’s marginal utility will diminish with additional units, until that product has little to no utility for the consumer.
According to the theory of marginal utility, prices are determined by subjective forces (namely, consumer desire) in addition to objective ones (for example, labor costs). This concept became one of the foundations of the law of supply and demand, the economic principle that explains how prices in a free-market economy are determined.
When Did It Begin
The concept of marginal utility arose in response to what is known as the “diamond-water paradox.” This was a dilemma that was first described by Scottish political economist Adam Smith (1723–90) in his landmark study An Inquiry into the Nature and Causes of the Wealth of Nations (1776). The diamond-water paradox asks a basic question: Why is water, which is absolutely essential to human existence, less valuable than diamonds, which have no function in maintaining life?
Smith argued that the price of a certain good was ultimately determined by labor. Producing water required relatively little labor because it was plentiful and therefore easy to acquire; diamonds, on the other hand, demanded a great deal of labor to obtain. In Smith’s view, the difference between the amount of labor required to obtain water and the amount required to obtain diamonds explained the difference in price.
Economists in the nineteenth century, however, found Smith’s explanation inadequate because it failed to account for the role that consumer desire played in determining a product’s price. They believed that a product’s utility affected price, but they still found it paradoxical that a product such as water, which has a high level of utility, cost less than diamonds. These economists realized that the paradox could be solved by taking into account the amount of the product that a consumer already possesses. This developed into the theory of marginal utility, which stated that price was determined not by the utility of the first unit of a good (a person with no water and no diamonds would get more satisfaction from a glass of water than a diamond) but by how much consumer desire changed as additional units were acquired.
More Detailed Information
Economists developed the theory of marginal utility to describe the way that the desirability of a particular good changes as a consumer acquires more of that good and therefore to explain why certain goods are more expensive than others.
In the case of water, a consumer’s desire for water diminishes as his or her thirst is quenched. The first bottle of water has a significant marginal utility for the thirsty consumer. The second bottle is also desirable if the person is still thirsty, but probably not as desirable as the first bottle; thus, the second bottle has less marginal utility than the first. The third bottle is even less desirable, because at this point the person is not really thirsty; so this bottle’s marginal utility is lower than that of the second one. The fourth bottle may bring the consumer no satisfaction at all, because he or she cannot even swallow any more water, and the same with the fifth, sixth, and every additional bottle after that. In this example, each additional bottle has been less desirable than the one before it. With the addition of the fourth bottle of water, the marginal utility has reached zero: the consumer derives no additional satisfaction from that bottle.
On the other hand, while diamonds have no practical use to consumers, their rarity, combined with their beauty and allure, makes them extremely desirable to consumers. This high level of desirability gives them a high marginal utility, meaning that each additional diamond a person acquires continues to provide the same, or nearly the same, level of satisfaction (that is, utility) as the one before it.
In one respect, the theory of marginal utility rests on a simple premise: that consumers have a clear idea of what they want (in other words, of what objects have utility to them) and make their spending decisions with the aim of maximizing the overall satisfaction they derive from their purchases. The assumption is that, if a consumer spends money on a particular object, it is because he or she has rationally decided that the object has a level of utility greater than or equal to the price of the object.
Over the years, however, a number of economists have disputed the assertion that consumer desire is inherently rational. They argue that consumers often fail to maximize their overall satisfaction because their desire for a good can in fact lead to irrational economic judgments.
The early twenty-first century saw the emergence of a new theory called neuroeconomics, which set out to challenge the notion that economic decisions are made rationally. Neuroeconomics combines neuroscience (the study of the human nervous system), psychology (the study of human thought and behavior), and traditional economics to try to understand how the brain makes economic decisions. Whereas supporters of the marginal utility theory argue that all economic decisions, no matter how unreasonable they might seem, have a rational basis, neuroeconomists assert that certain poor economic decisions are inherently irrational. According to neuroeconomics, it is only by trying to develop a science of irrational consumer behavior that economists can hope to understand the real impetus for certain economic decisions.