Marginalism describes both an economical method of analysis and a theory of value. According to this theory, individuals make economic decisions "on the margin." That is, value is determined by how much additional utility an extra unit of a good or service provides.

It would be difficult to overstate how important this concept is to contemporary economic understanding. The development of marginal theory is commonly referred to as the Marginalist Revolution and is seen as the dividing line between classical and modern economics.

Key Takeaways

  • Marginalism is a theory that asserts individuals make decisions on the purchase of an additional unit of a good or service based on the additional utility they will receive from it.
  • Marginalist theory, known as the Marginalist Revolution, is seen as the dividing line between classical and modern economics.
  • Marginalism theory helps to better explain human rationality, human action, subjective valuation, and efficient market prices.
  • The difference between total utility and marginal utility is explained through marginalism.
  • Businesses can better understand how to price their products by understanding marginalism.

The Marginalist Revolution

Adam Smith was the founding father of economic science, but even he was perplexed by real economic value: Why do people sometimes value non-essential goods more than essential goods? A paradox in value appeared to exist that couldn't be rationally explained. This became known as the paradox of "value in use" versus "value in exchange."

The best-known example of this is the diamond-water paradox. Even though diamonds serve no vital purpose, and water is essential to human life, individual diamonds are far more valuable than individual units of water. On the surface, it seems like water should be worth more.

Independently and almost simultaneously, three economists solved this puzzle in the 1870s: William Stanley Jevons, Carl Menger, and Leon Walras. They suggested that individual consumers don't choose between all of the world's water versus all of the world's diamonds; obviously, they would pick water if given that choice.

Marginal utility is most often broken down into positive marginal utility, negative marginal utility, and zero marginal utility.

Rather, individuals pick between increments of a good. They separately determine the worth of having one additional unit of water or one additional unit of diamonds. These individual choices are made on the margin.

Ostensibly, water is far easier to come by, and most people already have access to enough water to fulfill their wants. In these conditions, the value of that extra unit of water is relatively low. This is not usually the case with diamonds because diamonds are expensive to buy.

Of course, an incredibly thirsty man in the desert might value that extra unit of water more than an extra diamond. This is the difference between total utility and marginal utility.

Why Is Marginalism Important?

The development of marginalist theory helped to better explain human rationality, human action, subjective valuation, and efficient market prices. In doing so, marginal analysis opened the door for a new era in microeconomics.

Marginal utility can be difficult to gauge as it is hard to assess how much utility an individual gets from one more unit of a good or service, especially since this measurement is different for every individual. This concept is laid out in the law of diminishing marginal utility, which states that as consumption increases, utility decreases.

For example, if someone is craving a cheeseburger, they may be willing to pay extra for a cheeseburger if they were really hungry, let's say, $10. Now, after the first cheeseburger, the same individual might still be hungry but thinks spending $10 on another cheeseburger is too much.

They would, however, buy another cheeseburger if it cost $5 instead of $10. This law of diminishing marginal utility shows that the value of a cheeseburger is less once an individual increases their consumption of it.

Marginalism helps businesses price their goods accurately as it gives an insight into what a consumer values. The price decreases as consumption increases and vice versa. Price and quantity, therefore, have an inverse relationship.

The Bottom Line

Marginalism seeks to understand the additional value a consumer gains from an additional unit of a good or service and how their purchasing decisions are affected by that.

Businesses can use marginalism to correctly price their products to ensure that they are at a value that people will continue to buy or even buy in the first place. It is an important area of economics that tries to understand the behavior of individuals.