Marginal utility

The term utility just means our subjectively determined benefits. The greater the quantity of the good we consume, the greater we expect our total utility to be. But additional units can only be put to less valuable uses, so marginal utility must fall.

Over a particular range the more slices of pizza we eat, the happier we feel. As the quantity consumed rises so does total utility. But the first slice satisfies a more pressing need than the second. And the third slice brings even less pleasure. Marginal utility declines. The term satiation refers to the point at which marginal utility becomes zero, and total utility stops increasing. If you consume more than this point, marginal utility is negative, and you become less and less happy. The common term for this is “vomiting”. When marginal utility becomes negative you would be willing to pay money not to consume additional units. Pizza is no longer a good, it becomes a “bad”. DMU is a simple, but powerful concept. It states that the more you have of something, the less you value additional units.

The rate of DMU will be different for different goods, and we would expect DMU to be more pronounced for perishable, or sickly, goods. Since you can store toilet roll you would probably be willing to pay a similar amount of money for a sixth roll as for the first. Therefore non-perishable (i.e. durable) goods tend to have a low rate of DMU. Conversely, I once bought a roast chicken from a supermarket at 8 p.m. and was offered a second one for just 50p. But even though I had paid £5 for the first one another wasn’t much use to me. The man behind the deli counter thought it was a bargain. I thought it was worthless. MU diminished rapidly. Similarly, you might be willing to treat yourself and pay £10 for a slice of rich chocolate torte in a fancy restaurant, but are unlikely to want to pay the same amount for another one.

The concept of marginal value was a breakthrough in economic thought because it solved a perennial mystery: why are people willing to pay more for diamonds than they are for water? As Adam Smith himself put it,

Nothing is more useful than water; but it will purchase scarce anything … A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.

Smith, A., 1776/1981, ‘The Wealth of Nations’, (Book 1, Chapter 4, 44-45; original format)

We’ve mentioned already that value stems from the ability to satisfy our pressing needs. We all recognize that water is essential for life, and by contrast diamonds are largely decorative. Surely survival is a more pressing need than a nice piece of jewellery? And yet people save up for months to buy an engagement ring. It’s tempting to explain this paradox by saying that diamonds are scarcer, but scarcity isn’t enough. Lots of things are “scarce” but if they don’t fulfil our needs they’re not valuable. The solution lies in the fact that we always act on the margin. In other words we’re never asked to choose between “water” and “diamonds”. Rather, we choose between additional units of water and additional units of diamonds.

We don’t buy the concept of diamonds, we buy some amount more than we currently own. Therefore, the value we place on goods comes from the needs that are satisfied by additional units. Because most of us consume a lot of water, additional units of water would only be put to satisfy minor needs. By contrast most people don’t have many diamonds at all, so additional diamonds are highly sought after. There are diminishing marginal returns to both, but at any moment in time we’re higher up the scale when it comes to diamonds. Our willingness to pay is based on marginal value, and not some intrinsic property contained within the good.