Marginal Utility Theory: Types and Applications

What is Marginal Utility? 

 

There are many concepts that can get altered as and when an individual’s income gets changed. In economics, the decrease or increase in an individual’s income results in a change in his/her purchasing patterns, consumption of goods or services. 

 

A concept that is influenced by the consumption of goods or services by an individual in relation to a change in his/her income level is marginal utility. 

 

The concept of marginal utility of income is a significant topic in the subject of economics that refers to the satisfaction or benefit gained by consuming a product or service in an increased quantity. 

 

This concept helps economists to determine how much of a commodity or an item the consumers are willing to purchase to satisfy their needs. In the retail industry, consumer behavior is a crucial concept that must be understood by businesses in order to forecast sales. 

 

(Must read: Capital in Economics - Characteristics, Types and Functions)

 

Similarly, the economic behavior of consumers from different income backgrounds is of great interest to economists as well. 

 

That said, the concept of marginal utility helps economists to understand how an increase or decrease in an individual’s income level affects his/her marginal utility of money while consuming goods or services. 

 

Herein, the concept of utility can be understood as a determinant of satisfaction that a consumer gains after consuming a particular good or a service. For instance, the utility of dining in a restaurant is substantial to a consumer who has been consuming homemade food for the past week. 

 

While some goods give us satisfaction, other commodities do not do well when it comes to utility. Therefore, utility varies from product to product. Since we have now understood what defines utility, we will now understand the true definition of marginal utility. 

 

Defined as the satisfaction that a consumer gains on consuming additional units after the first unit, marginal utility looks beyond the consumption of the first utility. For instance, a person having doughnuts will certainly derive satisfaction from this act. 

 

The marginal utility (satisfaction on additional consumption) will determine how well the consumer likes to purchase or consume a commodity or a service. Having one doughnut will not likely give him/her the kind of satisfaction that having 3-4 doughnuts will. Thus, marginal utility tends to measure the level of satisfaction gained from a certain point (consumption of the first unit). 

 

Yet, it is important to note that while certain levels after the first unit might lead to added marginal utility, this satisfaction tends to decrease with the increasing consumption. 

 

(Must read: Types of Elasticity in Economics)

 

How does it work? 

 

The concept of marginal utility must be clear by now. However, we will dig a bit deeper into the concept to discover how it actually works. Economists calculate marginal utility using the given below marginal utility formula -

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Marginal Utility Formula, Source 

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The steps to calculate marginal utility are as follows -

 

1. First Total Utility - The very 1st step to calculate marginal utility is to calculate the first total utility. Total utility refers to the customer satisfaction of a product or a commodity. This can be calculated by summing up the prices of the first and each additional product that a customer is willing to pay for the utility. 

  

2. Second Total Utility - The value of the second total utility is to be calculated when the customer comes back to the store willing to gain that satisfaction. Yet, it is now to be observed how much a customer is willing to pay for a particular number of products. 

 

3. Difference between the Total Utilities - Once the 1st and 2nd total utilities can be calculated, it is time to calculate the difference between the total utilities. The obtained result must be kept aside. 

 

4. Difference between the Number of Goods - The next step is to calculate the difference between the number of items purchased in the two visits. Since the customer has already consumed a particular item, the number of items purchased will eventually change. 

 

5. Calculating Marginal Utility - The final step is to calculate the marginal utility of a product. Apply the above-mentioned formula and this will derive the marginal utility of a product. 

 

Since the total utility refers to the level of satisfaction derived from consuming a commodity from scratch, marginal utility is calculated by finding the difference between the current total utility and the previous one. A number of factors influence the marginal utility of a commodity. 

 

To begin with, the utility of a commodity might not remain constant. What used to give utmost satisfaction to an individual might lead to diminishing marginal utility as soon as the saturation level is reached. 

 

For a child, having 4 candies might lead to marginal utility, however, as soon as she eats 10 candies she feels full. Hence, having the 11th candy might lead to a negative marginal utility, implying diminishing marginal utility.

 

(Reference reading: Big Data in Economics and Policy)

 

 

Types of Marginal Utility

 

Invented as a response to find out the economic reality of price in an economic market, the law of marginal utility aims to examine the purchasing pattern of a commodity in relation to the utility derived from it on the consumer end. 

 

With time, many hypotheses led to the theory of marginal utility. In essence, marginal utility can be positive, negative, or zero. 

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Positive Marginal Utility

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1. Positive Marginal Utility

 

Positive marginal utility refers to the added satisfaction or happiness that a consumer feels when s/he consumes extra benefits. 

 

Simply put, positive marginal utility refers to the benefit that a consumer gains while consuming a commodity or a service. For instance, an individual is eating a slice of a cake. 

 

The added consumption of more than one slice will give happiness to the person leading to increasing marginal utility (positive marginal utility). 

 

2. Zero Marginal Utility

 

Zero marginal utility is the second type of marginal utility that implies that the added consumption of a commodity leads to neither happiness nor harm. 

 

For instance, when a person is having lunch, s/he will not enjoy a second meal as the appetite would have been sufficed by then. Perhaps this is an example of zero marginal utility that brings no added satisfaction to the consumer. 

 

(Recommended blog: Cost of Production)

 

3. Negative Marginal Utility

 

The third type of marginal utility is a bit different from the first two types. 

 

While positive marginal utility and zero marginal utility define the absence or presence of satisfaction on the consumption of extra units, negative marginal utility implies that the consumption of added units leads to harm instead of happiness. 

 

This means that an individual has had too much of a commodity that s/he might become unhappy if s/he keeps consuming that particular item. For example, having too many chocolate bars can make a person sick leading to negative marginal utility. 

 

In such a case, the consumer does not derive happiness but harm. This may also lead to the law of diminishing marginal utility.   

 

“Thus, the marginal utility to a buyer of a product decreases as he purchases more and more of that product, until the point is reached at which he has no need at all of additional units. The marginal utility is then zero.”

Understanding Marginal Utility 

 

Applications of Marginal Utility

 

Now, let us discover the real-world use of the concept of marginal utility. 

 

1. Understanding Consumer Behavior

 

One of the biggest applications of marginal utility theory is that it helps retail businesses in formulating assumptions based on consumer behavior. 

 

By extracting insights into the psyche of consumers and discovering how much a consumer is willing to pay for a commodity and for how many units, it is helpful for companies to place the worth of their products and target customers accordingly. 

 

2. Product Pricing

 

Another application of marginal utility is in the field of product pricing. As soon as companies discover the worth of their products with the help of consumer behavior, they are all set to determine the prices of their products. 

 

By testing an aggregate price a consumer is willing to pay for a commodity, companies usually fix the prices of their product in that particular price bracket to make their products a success in the market. 

 

(Also read: Types of Taxes)

 

3. Progressive Taxation Policies

 

The third of all applications of marginal utility can be observed in the field of progressive taxation policies while fixing the rate of taxes. 

 

As utility determines the purchasing behavior of consumers, it is directly proportional to the taxation system that is put in place by the government of a country. 

 

Assuming that people with high incomes are able to spend more in comparison to the people who earn less. Whereas a flat taxation policy can have harmful repercussions on the income of the consumers.