What Is Marginal Utility?

Marginal utility quantifies the added satisfaction that a consumer garners from consuming additional units of goods or services. The concept of marginal utility is used by economists to determine how much of an item consumers are willing to purchase. Positive marginal utility occurs when the consumption of an additional item increases the total utility, while negative marginal utility occurs when the consumption of an additional item decreases the total utility.

How Marginal Utility Works

Economists utilize the concept of marginal utility to gauge how satisfaction levels affect consumer decisions. Economists have also identified a concept known as the law of diminishing marginal utility, which describes how the first unit of consumption of a good or service carries more utility than subsequent units.

Example of Marginal Utility

Marginal utility may be illustrated by the following example.

David has four bottles of water, then decides to purchase a fifth bottle. Meanwhile, Kevin has 50 bottles of water and likewise decides to buy an additional bottle. In this case, David experiences more utility, because his extra bottle increases his total water supply by 25%, while Kevin’s additional bottle augments his supply by a mere 2%.

The chief takeaway from this scenario is that the marginal utility of a buyer who acquires more and more of a product steadily declines until he has zero need for any additional units of the good or service. At that point, the marginal utility of the next unit equals zero.

The concept of marginal utility sprouted from the minds of 19th-century economists who were attempting to explain the economic reality of price, which they believed was driven by a product’s utility. However, this led to a conundrum known as the “the paradox of water and diamonds,” which is attributed to “The Wealth of Nations” author Adam Smith, which states that water has far less value than diamonds, even though water is vital to human life. Since marginal utility and marginal cost are used to determine price, this is paradoxical because the marginal cost of water is much lower than that of diamonds.

Key Takeaway

• Marginal utility quantifies the added satisfaction a consumer garners from consuming additional units of goods or services.
• The concept of marginal utility is used by economists to determine how much of an item consumers are willing to purchase.
• Positive marginal utility occurs when the consumption of an additional item increases the total utility, while negative marginal utility occurs when the consumption of an additional item decreases the total utility.
• The concept of marginal utility sprouted from the minds of 19th-century economists who were attempting to explain the economic reality of price, which they believed was driven by a product’s utility.

There are multiple kinds of marginal utility. Three of the most common ones are as follows:

• Zero marginal utility is when having more of an item brings no extra measure of satisfaction. For example, if you receive two copies of the same issue of a magazine, that extra copy has little added value.
• Positive marginal utility is when buying extra versions of an item is satisfying. One such example would be a store promotion where customers can walk out with a free pair of shoes if they buy two pairs up front.
• Negative marginal utility is where too much of an item is actually detrimental. For example, while the correct dose of antibiotics can kill harmful bacteria, too much can harm a person’s body.

Here is my Power Point presentation on The Water Diamond Paradox

If you would like to check my pliant focused on the Ten Principles of Economics.

There is some debate as to whether opportunity costs can in fact be negative. The argument goes that opportunity costs are the profit foregone from choosing the next best alternative. The key concept in this argument is “the profit foregone” not the cost foregone. But this approach fails to consider the possibility that an investor could easily be faced with the choice between making an investment or paying down a loan. When a liability or debt is involved, then the choice changes from “what is the lost opportunity of not making a particular choice” to “what is the potential realized loss from not taking a certain action?”

Perhaps an example will help. Let’s say you have $10,000 to invest and are able to purchase a fixed income investment that will pay you 5% annually, giving you $500 per year. At the same time, let’s say you have a mortgage on your house that is costing you 7% annually. If you use the $10,000 to help pay down the mortgage instead of investing it, you are saving 7% in interest expense, or $700. In other words, by paying down the principal on the mortgage by $10,000, you won’t have to pay 7% on this borrowed money, saving yourself $700 a year, which is the same thing as earning $700.

So here you are faced with an opportunity cost that could potentially be negative. How? Because the 7% rate of borrowing is higher than the 5% investment return, if you chose to make the investment instead of paying down the loan you will have a negative opportunity cost at the end of the year. $10,000 at 7% is $700 in interest expenses on the mortgage, while $10,000 at 5% is $500 in income from the investment. By not using the money to pay down the mortgage, the opportunity cost is $200 in net interest expense. This is a negative opportunity cost. It is $200 out of your pocket as a cost, rather than a foregone profit.

Using our earlier calculation for opportunity cost you get:

Opportunity cost of not paying down the mortgage: ($700) / $500 = ($1.40) per year

In words, for every dollar you earn from the investment, you sacrifice the opportunity to reduce debt by $1.40 over the course of a year. The cost is negative for two reasons. First, every dollar of investment is insufficient to cover the interest you are paying by $0.40. Second, every dollar of return on your investment is offsetting the interest expense as well.

In our example above if the investment had a return of 5% and the loan had an interest rate of 5% then the opportunity cost would be zero. The return would offset the interest expense and the investor would be no better or worse off from making one decision over another.

Please check my wonderful prezi presentation:
https://prezi.com/view/opkagx1qHJTXMwmsBadz/