The marginal utility of income is the change in utility, or satisfaction, resulting from a change in an individual's income. In economics, utility is defined as the total satisfaction, usefulness, or happiness gained from consuming a good or service. Marginal utility is defined as the change in satisfaction resulting from a given change in the consumption of a good. Economists use marginal utility to determine the amount of an item that consumers are willing to purchase.

Key Takeaways

  • The marginal utility of income is the change in utility, or satisfaction, resulting from a change in an individual's income.
  • In a modern economy, individuals trade away their incomes in order to satisfy their wants and remove discomforts, and they do this by buying food, clothing, shelter, entertainment, etc.
  • According to the law of diminishing marginal utility, the more of a good that is consumed, the less additional satisfaction can be derived from consuming another unit; the law of diminishing marginal utility of income suggests that as income increases, individuals gain a correspondingly smaller increase in satisfaction.

Marginal utility is diminishing in nature; in general, as income increases, individuals gain a correspondingly smaller increase in satisfaction. The economist Alfred Marshall popularized the concept of marginal utility in the 19th century, although the term is originally credited to an Austrian economist named Friedrich von Wieser. In the 1890 book "Principles of Economics," Marshall says, "The additional benefit a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has."

Individuals Maximize Utility Through Income

Income comes in the form of wages, rents, investment returns, and other transfers. In a modern economy, individuals trade away their incomes in order to satisfy their wants and remove discomforts, and they do this by buying food, clothing, shelter, entertainment, etc.

The field of economics argues that human beings seek to maximize their utility by spending their income first on things they value the most (those items that have the highest "utility"). If an individual receives $10 in additional income, and they use that $10 to buy a movie ticket rather than two new pairs of socks, it means they momentarily value the admission to see the movie more than new socks. On a scale of utility, the movie ticket is ranked first for this individual and socks are ranked lower.

Economists have attempted to quantify how fast the marginal utility of income declines as income increases in order to determine optimal taxation rates and to better understand and measure inequality.

The diminishing marginal utility of income suggests that as an individual's income increases, the extra benefit to that individual decreases. This is because each subsequent dollar is satisfying less and less urgent wants.

Example of Diminishing Marginal Utility of Income

Suppose you have zero income and your income increases to $200 per week. This $200 will significantly improve your standard of living by allowing you to buy food, shelter, and heating.

However, if you already earn $600 per week and your income increases by $200, this additional income has a proportionately smaller impact on improving your standard of living. With an additional $200, you may be able to order takeout dinner more often, but your standard of living hasn't been drastically changed. At $600 per week, you can afford to buy most things you need. But most people would be happy to earn an extra $200 per week to spend on discretionary expenses.

However, suppose you already earn $10,000 per week. An additional $100 of income will have no noticeable impact on your life. Because you may not even have the time to spend it, this extra income is more likely to just be saved.