Utility and the law of diminishing marginal utility

The first cold drink on a hot afternoon in Kenema is wonderful; the fourth, much less so. That everyday experience is one of the most useful laws in economics, and it explains why demand curves slope downwards.

Learning objectives

By the end of this lesson you should be able to:

• define utility and distinguish total, average and marginal utility
• calculate utility from a table and describe the shape of the curves
• state and explain the law of diminishing marginal utility and the paradox of value

What is utility?

Utility is personal: a cold drink gives great satisfaction to a thirsty footballer and very little to someone who has just had three. Utility cannot be measured exactly, but economists use imaginary units called utils to explain consumer behaviour. This is called the cardinal approach.

Total, average and marginal utility

The shape of the curves

Plot TU and MU against the number of oranges:

1. While MU is positive, TU rises, but more and more slowly.
2. When MU is zero, TU is at its maximum (the 6th orange). This is the point of satiety: Fatmata is fully satisfied.
3. When MU is negative, TU falls. The 7th orange makes her feel worse (disutility).

The MU curve slopes downwards and crosses the quantity axis where TU is at its peak.

Figure 1. Total and marginal utility of oranges. WASSCE Tutor diagram.

Utility here is measured in imaginary units called utils, as if satisfaction could be counted. This is the cardinal approach to utility. In reality satisfaction cannot be measured exactly, but consumers can still rank what they prefer, which is the ordinal approach. WASSCE questions use utils, as in this table.

The law of diminishing marginal utility

Assumptions of the law

1. The units are identical in size and quality.
2. Consumption is continuous: the oranges are eaten one after another, not one today and one next month.
3. The consumer's tastes and income do not change.
4. The consumer is rational.

Exceptions

• Collections and hobbies: a stamp or coin collector may gain more satisfaction from each new item that completes a set.
• Addictive goods: alcohol or drugs may seem to give rising satisfaction.
• Money: many people never feel they have enough (although each extra leone matters less to a rich person than to a poor one).

The law and the demand curve

Because each extra unit gives less satisfaction, a consumer will buy more units only if the price falls. This is one reason the demand curve slopes downwards.

The paradox of value

Water is essential for life, yet it is cheap. Diamonds are not needed for survival, yet they are very expensive. Why?

Key points

• Utility = satisfaction. TU = total, AU = TU ÷ Q, MU = extra satisfaction from one more unit.
• When MU is positive, TU rises; when MU is zero, TU is at its maximum; when MU is negative, TU falls.
• Law of diminishing MU: extra satisfaction from each extra unit eventually falls.
• Price depends on marginal utility, which explains the diamond–water paradox.

WASSCE examination focus

Quick check

1. If TU from 4 units is 40 and from 5 units is 45, what is the MU of the 5th unit?
2. What is total utility doing when marginal utility is zero?
3. Why are diamonds dearer than water?

Answers: 1. $45 - 40 = 5$ utils. 2. It is at its maximum. 3. Diamonds are scarce, so their marginal utility is high; water is plentiful, so the marginal utility of the last unit is low. Price reflects marginal, not total, utility.