Marginal utility
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In economics, marginal utility is the least urgent use of an object in satisfying a want - in other words, the use that is in the "margin." Marginal utility is subjective, because it depends on each person's wants and tastes. The same object may have different marginal utilities for different people. The concept grew out of attempts by 19th-century economists to explain the fundamental economic reality of price. It was a term coined by the Austrian economist Friedrich von Wieser.
For example, let us assume that a person has three wants and the satisfaction of each want each requires one gallon of water, so that satisfying all his wants requires three gallons of water. In descending priority, the most urgent want is to satisfy his thirst, the second most want is to give water to his dog, and his least urgent want is to water his roses. The least urgent use (the marginal utility) of one gallon of water when he has two is therefore to give water to his dog. If he has three gallons of water, then the least urgent use would be to water his roses. The "marginal utility," of any given gallon of water depends on how much water he has.
The concept of marginal utility is said to explain the "diamond-water paradox" most usually associated with Adam Smith. Smith asked, if water is more useful than diamonds, then why does water have a lower market price than diamonds? Marginalists answer that it is not the total usefulness that matters, but the usefulness of each unit of water. It is true that the total utility of water to people is tremendous, because they need to survive. However, since water is in such large supply in the world, the marginal utility of water is low. In other words, each additional unit of water that becomes available can be applied to less urgent uses as more urgent uses for water are satisfied. Therefore, any particular unit of water becomes worth less to people as the supply of water increases. On the other hand, diamonds are in much lower supply. They are of such low supply that the usefulness of one diamond is greater than the usefulness of one glass of water which is in abundant supply. Thus, diamonds are worth more to people. Therefore, those who want diamonds are willing to pay a higher price for one diamond than for one glass of water and sellers of diamonds ask a price for one diamond that is higher than than for one glass of water.
Diminishing marginal utility implies that marginal utility from one additional unit is inversely related to the number of units already owned. For example, the marginal utility of one slice of bread offered to a family that has five slices will be great, since the family will be less hungry and the difference between five and six is proportionally significant. An extra slice offered to a family that has 30 slices will have less marginal utility to the family, since the difference between 30 and 31 is proportionally smaller and the family's appetite may be satisfied by what it already has. Note that this example assumes that nothing else has changed. If the family that starts with only five slices also has much more cake than the family with 30 slices, then diminishing marginal utility need not apply. Also, if tastes or preferences vary between families or over time, this kind of differences in marginal utility need not apply. (Note also that this example assumes that each family has a unified utility function, rather than being a collection of indivdiuals each with his or her own preferences.)
Diminishing marginal utility is a very common assumption in economics, but it is not universally assumed. It corresponds to convexity of the indifference curves.
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[edit] History
[edit] Jevons, Weiser and the Labour Theory of Value
Weiser may have coined the term "marginal utility theory" but it was the English economist Jevons who proposed the essentials of the theory in a paper presented to the British Association in 1862. Jevons' "Theory of Political Economy" 1871, Menger's Grundsatze 1871 and Walras' Elements in 1874, all proceeded Weiser's key papers "The Origin and Law of Economic Value" 1884 and "Natural Value" 1889.
Jevons developed his theory as a reaction to the Ricardian Labour Theory of Value, Ricardo's theory which asserted that value arose in labour, not utility, was the pre-vailing orthodoxy of Victorian classical economics until the mid-1850s. In the preface to the 2nd edition of the Theory of Political Economy Jevons speaks of reshunting the "car of economic science" which Ricardo had so perversely directed "onto a wrong line." Indeed in a much quoted passage Jevons' wrote "Repeated reflection and inquiry have led me to the somewhat novel opinion, that value depends entirely upon utility. Prevailing opinions make labour rather than utility the origin of value..." (p2)
In contrast to Jevons, the Austrians, like Weiser and Bohm-Bawerk, were opponents not of Ricardianism but of Marx another famous proponent of a version of the labour theory of value who, although a contemporary of Jevons, it is unlikely he ever read.
The Marginalists argued that the price of the commodity was whatever a consumer would pay for it, they had a subjective rather than objective theory of value, which nonetheless left open the question what determines the amount a consumer can pay, what is the effect of purchasing power on prices?
[edit] Natural Value and Exchange Value
Weiser was at least aware of this point he wrote in his "Natural Value"; "A second element mingles itself in the formation of exchange value, namely purchasing power. In natural value goods are estimated simply according to their marginal utility in exchange value according to a combination of marginal utility and purchasing power..." (Natural Value p49-50)
For Ricardo and Marx and according to the labour theory of value, the relations of distribution were determined prior to exchange and arose in production. (Ricardo's conditions of production of wage goods; Marx's social relations of production). Ricardo and Marx believed that these relations of distribution determined how much a consumer could pay for a commodity and that through explaining these relations of distribution originating in production, they could explain value and price.
In contrast Marginal Utility Theory which asserts that all prices arise in the act of exchange can neither explain the origin of the relations of distribution, or their effect on prices.
The Austrian economist Eugen von Böhm-Bawerk gave probably the most memorable description of the marginal theory of value, one often used by economics textbooks, which neatly encapsulates this confusion between the natural economy and the market economy. Loosely translated it is:
"A pioneer farmer had five sacks of grain, with no way of selling them or buying more. He had five possible uses: as basic feed for himself, food to build strength, food for his chickens for dietary variation, an ingredient for making whisky and feed for his parrots to amuse him. Then the farmer lost one sack of grain. Instead of reducing every activity by a fifth, the farmer simply starved the parrots as they were of less utility than the other four uses; in other words they were on the margin. And it is on the margin, and not with a view to the big picture, that we make economic decisions." [1] Positive Theory of Capital (1889)p143
Bohm-Bawerk describes a mechanism for price formation, in a situation where prices are not formed, the farmer can neither buy nor sell his output. If the farmer produced within a capitalist economy it would be the price of his output, not its use, i.e. its exchange value not its use value which determined whether he sold it or consumed it. If he could sell his grain for a higher price than the cost of food, chickens, whiskey or parrots, he would sell the grain and buy the food, chickens, whiskey and parrots. The price that the farmer receives for his output would be something entirely separate from its utility for him, consequently its utility for him cannot determine its price.
Further the vast bulk of production in a modern market economy is by capitalists employing workers, not by simple commodity producers like small farmers. Capitalists produce not to consume their output but to sell it, the utility of the commodities they produce is immaterial to them, all that matters is the amount of profit it yields on their investment. Workers do not own the production they produce for the capitalist as they have already alienated their labour power in the act of employment. In neither case does the choice Bohm Bawerk describes apply.
[edit] Psychological basis
Austrian economists formulated the law of marginal utility in a period when psychologists were much interested in the Weber-Fechner law of sensation. The Weber-Fechner law states that in order that the intensity of a sensation may achieve an arithmetic progression, the stimulus itself must achieve a geometric progression. For example, in a quiet environment, humans will notice even a small increase in noise level, but when the given noise level is already loud, humans will need a much larger increase in order to perceive a difference.
Von Wieser's seminal essay on "Natural Value" appeared in 1889. In 1890, the American psychologist William James wrote his Principles of Psychology and offered an interpretation of the Weber-Fechner law that may also shed a lot of light on marginal utility in von Weiser's sense. James saw the Weber-Fechner law as a rough generalization as to the friction in the neural machinery.
"If our feelings [of weight, sight, sound, etc.] resulted from a condition of the nerve molecules which it grew ever more difficult for the stimulus to increase, our feelings would naturally grow at a slower rate than the stimulus itself," he wrote. "An ever larger part of the latter's work would go to overcoming the resistances, and an ever smaller part to the realization of the feeling-bringing state."
Whatever the neurological basis, the result of diminishing marginal utility is that rather than having a lot of one good or a lot of another one, one prefers having some of both. In the case of perfect substitutes this result does not apply (since the two products are essentially the same), in the case of perfect complements it applies most.
