Marginal Utility
Review the fundamental economic problem: it will help with understanding the WHY, not just the WHAT of this section.
Marginal utility is the additional utility, expressed in an imaginary unit made up by economists called “utils,” gained from one additional unit. Through marginal utility, we can figure out when diminishing returns begin, as well as when negative returns begin. Assume:
- Total utility of eating the first slice of pizza: 4
- Second: 9
- Third: 20
- Fourth: 28
- Fifth: 31
- Sixth: 30
See if you can figure out the marginal utility of consuming each slice of pizza before looking below.
- First: 4
- Second: 5
- Third: 11
- Fourth: 8
- Fifth: 3
- Sixth: -1
The marginal utility of consuming the Nth unit is simply the total utility AFTER consuming the Nth unit subtracted by the total utility BEFORE consuming the Nth unit. Here, marginal utility increases until the fourth unit, where it begins to decrease – that’s diminishing returns. Eventually, it even becomes negative; negative returns begin at the sixth slice.
Let’s make things a bit less simple. Imagine you can choose between buying pizza and hotdogs. How do you know which one to buy, economically speaking? Well, that’s where the optimal consumption rule comes into play.
Source: Chegg
It’s not that complicated. Rather than looking solely at marginal utility, we’re now looking at marginal utility per dollar, which just means we’re dividing the utils gained from buying a good by the price of that good. For many people, buying a new house may produce more marginal utility than buying a bag of chips, but the marginal utility PER DOLLAR of buying the house might not be as great as the marginal utility per dollar of buying the chips.
When tasked with choosing either pizza or hotdogs, consumers maximize utility by choosing whichever option has the higher marginal utility per dollar. After choosing one option, the marginal utility per dollar of picking that option again will decrease due to diminishing marginal utility. Consumers will keep picking the option with the higher marginal utility until the marginal utility per dollar is the same for each choice.