In economics, the law of diminishing marginal utility states that the marginal utility of a good or service declines as its available supply increases. Economic actors devote each successive unit of the good or service towards less and less valued ends. The law of diminishing marginal utility is used to explain other economic phenomena, such as time preference.

Whenever an individual interacts with an economic good, he or she necessarily acts in a way that demonstrates the order in which he or she values the use of that good. Thus, the first unit of a good is dedicated to the individual's most valued end, the second unit is devoted to the second most valued end and so on.

Consider a man on a desert island after a case of bottled water washes on shore. He might drink the first bottle, indicating that satisfying his thirst was the most important use of the water. He might bathe himself with the second bottle, or he might decide to save it for later. If he saves it for later, he is indicating that he values the future use of the water more than bathing today, but still less than the immediate quenching of his thirst. This is called ordinal time preference. This concept helps explain savings and investing versus current consumption and spending.

It also helps explain why demand curves are downward-sloping in microeconomic models, since each additional unit of a good or service is put toward less valuable ends. This application of the law of marginal utility demonstrates why a rise in the money stock (other things being equal) reduces the exchange value of a money unit, since each successive unit of money is used to purchase a less valuable end.

It also provides an economic argument against the manipulation of interest rates by central banks, since the interest rate affects the saving and consumption habits of consumers or businesses. Distorting the interest rate encourages consumers are encouraged to spend or save out of accordance with their actual time preferences, leading to eventual surpluses or shortages in capital investment.

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  2. What is the concept of utility in microeconomics?

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  3. What is the utility function and how is it calculated?

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  4. How can marginal utility explain the 'diamond/water paradox'?

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  5. Why do utility stocks pay high dividends?

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