What Is the Law of Diminishing Marginal Utility? With Example

What Is the Law of Diminishing Marginal Utility?

The law of diminishing marginal utility states that all else equal, as consumption increases, the marginal utility derived from each additional unit declines. Marginal utility is the incremental increase in utility that results from the consumption of one additional unit. "Utility" is an economic term used to represent satisfaction or happiness.

In simple terms, the law of diminishing marginal utility means that the more of an item that you use or consume, the less satisfaction you get from each additional unit consumed or used.

Understanding the Law of Diminishing Marginal Utility

To understand how the law of diminishing marginal utility affects both consumers and businesses, it can be helpful to break down its components.

Understanding Utility

The utility is the degree of satisfaction or pleasure a consumer gets from an economic act. For example, a consumer can purchase a sandwich so they are no longer hungry, thus the sandwich provides some utility.

Understanding Marginal Utility

Marginal utility is the enjoyment a consumer gets from each additional unit of consumption. It calculates the utility beyond the first product consumed. If you buy a bottle of water and then a second one, the utility gained from the second bottle of water is the marginal utility.

Understanding Diminishing Marginal Utility

The law of diminishing marginal utility directly relates to the concept of diminishing prices. As the utility of a product decreases as its consumption increases, consumers are willing to pay smaller dollar amounts for more of the product. For example, assume an individual pays $100 for a vacuum cleaner. Because he has little value for a second vacuum cleaner, the same individual is willing to pay only $20 for a second vacuum cleaner.

The marginal utility may decrease into negative utility. At that point, it's entirely unfavorable to consume another unit of any product. Therefore, the first unit of consumption for any product is typically highest. After that, every unit of consumption to follow holds less and less utility. Consumers handle the law of diminishing marginal utility by consuming numerous different goods, keeping the utility high for each one.

The law of diminishing marginal utility directly impacts a company’s pricing because the price charged for an item must correspond to the consumer’s marginal utility and willingness to consume or utilize the good.

Examples of the Law of Diminishing Marginal Utility

Imagine you can purchase a slice of pizza for $2. You're very hungry, so you decide to buy five slices of pizza. When you eat the first slice of pizza, you gain a certain amount of positive utility from eating. Because you were hungry and this is the first food you are eating, the first slice of pizza has a high benefit.

After you eat the second slice of pizza, your appetite is becoming satisfied. You're not as hungry as before, so the second slice of pizza had a smaller benefit and enjoyment than the first. The third slice holds even less utility since you're only a little hungry at this point.

The fourth slice of pizza has experienced a diminished marginal utility as well. It might be difficult to eat because you're already full from the first three slices. Finally, you can't even eat the fifth slice of pizza. You're so full from the first four slices that consuming the last slice of pizza results in negative utility.

Examples of the Law of Diminishing Marginal Utility in Business

Businesses can use this principle to structure their workforce. For example, a company may benefit from having three accountants on its staff. If there is no need for another accountant, though, hiring another accountant results in a diminished utility, as there is a minimum benefit gained from the new hire. However, if you have two accountants but no one to process paperwork, hiring a new administrative assistant has a higher level of utility than hiring a third accountant.

The law of diminishing marginal utility can also affect what goods and services businesses offer to customers, as it encourages a certain level of diversification. In the above example with the pizza, if the consumer knows they won't want the fourth or fifth slice of pizza, they might not buy them in the first place. But they may see a high level of utility in a different food, such as a salad. By diversifying its menu, the shop selling pizza can avoid diminished marginal utility and encourage consumers to purchase more.

How the Law Affects Pricing

The law of diminishing marginal utility affects how businesses price their goods and services. Because the first quantity of something has the most utility, consumers are usually willing to pay more for it.

For example, a store might have a deal on backpacks for sale: one backpack for $30, two for $55, or three pairs for $75. A person buying backpacks can get the best cost per backpack if they buy three.

Not all buyers will want three backpacks, even though they are the best deal. However, anyone who is shopping for backpacks needs at least one, so the first backpack has the highest price. After that, because the marginal utility of each additional backpack decreases, the business must decrease the cost per unit in order to entice shoppers to purchase more units.

Limitations of the Law of Diminishing Marginal Utility

When it comes to making business decisions, there are some limitations to the law of diminishing marginal utility. The law will not operate properly, or may not even apply, if:

• The units being consumed are very small.
• The units being consumed are of different sizes.
• There are long breaks in between consuming the units.
• The consumer is thinking or behaving irrationally, or the consumer is suffering from a mental illness or addiction.
• The units being consumed are part of a collection or are rare objects.

The law of diminishing marginal utility also will not apply if the commodity being considered is money. The utility of money does not decrease as a person acquires more of it.

The Bottom Line

The law of diminishing marginal utility predicts how consumers will react to a certain level of supply. As they consume more units of a single type of good, the utility of each unit will decrease until the consumer doesn't want anymore. Businesses can use the law of diminishing marginal utility to understand consumer behavior, price their goods and services, and diversify their offerings.