Tuesday, February 18, 2014

Law of Diminishing Marginal Utility

Law of Diminishing Marginal Utility
The law of diminishing marginal utility explains an ordinary experience of a consumer. If a consumer takes more and more units of a commodity, the additional utility he derives from an extra unit of the commodity goes on falling. Thus, according to this law, the marginal utility decreases with the increase in the consumption of a commodity. When marginal utility decreases, the total utility increases at a diminishing rate.
According to Marshall, “The additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has”.
Assumptions of the Law
1. The units of consumption must be in standard units e.g., a cup of tea, a bottle of cool drink etc.
2. All the units of the commodity must be identical in all aspects like taste, quality, colour and size.
3. The law holds good only when the process of consumption continues without any time gap.
4. The consumer’s taste, habit or preference must remain the same during the process of consumption.
5. The income of the consumer remains constant.
6. The prices of the commodity consumed and its substitutes are constant.
7. The consumer is assumed to be a rational economic man. As a rational consumer, he wants to maximise the total utility.
8. Utility is measurable.
Suppose Mr X is hungry and eats apple one by one. The first apple gives him great pleasure (higher utility) as he is hungry; when he takes the second apple, the extent of his hunger will reduce. Therefore he will derive less utility from the second apple. If he continues to take additional apples, the utility derived from the third apple will be less than that of the second one. In this way, the additional utility (marginal utility) from the extra units will go on decreasing. If the consumer continues to take more apples, marginal utility falls to zero and then becomes negative.

Table 3.1 gives the utility derived by a person from successive units of consumption of apples. From Table 3.1 and figure 3.1 it is very clear that the marginal utility (addition made to the total utility) goes on declining. The consumer derives 20 units of utility from the first apple he consumes. When he consumes the apples continuously, the marginal utility falls to 5 units for the fourth apple and becomes zero for the fifth apple. The marginal utilities are negative for the 6th and 7th apples. Thus when the consumer consumes a commodity continuously, the marginal utility declines, reaches zero and then becomes negative.
The total utility (sum of utilities of all the units consumed) goes on increasing and after a certain stage begins to decline. When the marginal utility declines and it is greater than zero, the total utility increases. For the first four units of apple, the total utility increases from 20 units to 50 units. When the marginal utility is zero (5th apple), the total utility is constant (50 units) and reaches the maximum. When the marginal utility becomes negative (6th and 7th units), the total utility declines from 50 units to 45 and then to 35 units.

Importance of Law of DMU

(i) The Law of Diminishing Marginal Utility (DMU) is the foundation for various other economic laws. For example, the Law of Demand is the result of the operation of the Law of Diminishing Marginal Utility. In other words, as more and more units of a commodity are consumed, each of them gives less and less marginal utility. This is due to the operation of the Law of DMU. As utility falls, consumer is therefore willing to pay a lower price only.

(ii) The Law of DMU operates in the case of money also. A rich man already possesses a lot of money. If more and more money is newly added to his income, marginal utility of money begins to fall. Alfred Marshall assumed that the marginal utility of money remains Constant

(iii) This law is a handy tool for the Finance Minister for increasing tax rate on the rich.

(iv) Producers are guided by the operation the Law of DMU, unconsciously. They constantly change the design, the package of their goods so that the goods become more attractive to the consumers and they appear as ‘new goods’. Or else, the consumers would think that they are using the same commodity, over and over. In such a situation, the Law of DMU operates in the minds of the consumers. Demand for such commodities may fall.

The Law of DMU is criticised on the following grounds.

(i) Deriving utility is a psychological experience, When we say a unit of X gives ten units of utility, this means that utility can be measured precisely. In reality, utility cannot be measured. For example, when a person sees a film and says it is very good, we cannot measure the utility he has derived from it. However, we can measure utility indirectly by the cinema fare he is willing to pay.

(ii) The Law is based on a single commodity consumption mode. That is, a consumer consumes only one good at a time. This is an unrealistic assumption. In real life, a consumer consumes more than one good at a time.

(iii) According to the Law, a consumer should consume successive units of the same good continuously. In real life it is not so.

(iv) The Law assumes constancy of the marginal utility of money. This means the marginal utility of money remains constant, even when money stock changes. In real life, the marginal utility derived from the consumption of a good cannot be measured precisely in monetary terms.

(v) As utility itself is capable of varying from person to person, marginal utility derived from the consumption of a good cannot be measured precisely