If there’s a silent backbone to the understanding of economics, the law of marginal utility is it. I say it’s silent because other economic laws, such as supply and demand, tend to get far more play in typical economic discourse. But, as important as supply and demand is, marginal utility fills that important gap in the economic puzzle that tells us why certain things are demanded in the first place, and how that translates into a price for a given good. The best explanation I’ve heard on this subject comes from Joseph Salerno over at the Mises Institute. His lecture at this year’s Mises University was particularly good. So I’ll draw from Professor Salerno a lot.
A straight up definition of marginal utility is as follows: the value of any good to a person is determined by the use one would have for the least needed unit of that good. I know there are far more technically precise definitions out there, but that’s the gist of it. As usual, this is best shown by example. I’ll use Salerno’s example:
…let us examine the case of a hypothetical farmer who has a number of different wants that can be satisfied by a sack of grain. His most pressing want for a sack of grain is for use in producing a quantity of bread necessary to sustain his existence during the forthcoming year. Of next greatest importance is satisfaction of the want for an additional quantity of bread that allows him to preserve his health and vigor for the year. Ranked progressively lower in importance are uses for a sack of grain that satisfy the following wants: 3rd. for seed-grain to ensure a harvest a year hence, and thus his continued existence and health in the future; 4th. for the production of beer and whiskey; 5th. for feed to maintain farm animals whose dairy and poultry products allow him to enjoy a varied diet. We may further assume that the farmer experiences an additional fifteen unidentified wants of progressively lower rank, so that he would be unable to completely satisfy his wants for a sack of grain with a harvest yielding less than twenty sacks.
If we now suppose that his current harvest yields five sacks of grain of equal quality, then grain is for him a scarce good that must be economized-that is, used in satisfying only his five most important concrete wants, while foregoing the satisfaction of his fifteen less important wants. What is the value of a sack of grain in this case? Since all five sacks are, by hypothesis, qualitatively identical, they must be equal in value, and, yet, they satisfy wants of manifestly unequal importance.
…regardless of which particular physical unit of his supply was subtracted, the actor would economize by choosing to reallocate the remaining units so as to continue to satisfy his most important wants and to forego the satisfaction of only the least important want of those previously satisfied by the larger supply. It is, thus, always the least important satisfaction that is dependent on a unit of the actor’s supply of a good and, that, therefore, determines the value of each and every unit of the supply. This value-determining satisfaction soon came to be known as the “marginal utility.”
So, to put it succinctly, the value to you of a certain good, is always going to be equal to the value you give to the unit of that good that satisfies the least of your wants. So, let’s say you have an XBOX. What would another XBOX be worth to you? Currently, XBOX’s are priced at $299 in retail stores. So, why do you not go out and buy another one for that price? It’s because the marginal utility of XBOX’s, to you, has dropped. One is all you really know what to do with. And any satisfaction that would be gleaned from having another is not worth $299. But, what if someone wanted to sell you an XBOX for $50? That price would be more likely to fall in line with your marginal utility valuation. You could probably add one to the upstairs TV for when guests come over, or something like that.
And that is the crux of this law. As your supply of a certain good goes up, the value of the whole of that good, to you, goes down so that, that particular good is only worth whatever value you place on having the least useful unit. Let’s look at another one of Salerno’s examples. Say you’re a farmer, and you have 3 horses and 2 cows. The first horse and second horse are used for plowing. The first cow is used for milk for you family. The second cow is used for butter and for selling excess milk. The final horse is used for pleasure riding. Now lets say that the stable where all these animals are kept catches fire and you only have time to save four animals. Which animal are you not going to save? Of course – the third horse.
In that scenario, the marginal utility of horses is lower to you than the marginal utility of cows. You will therefore save both cows and two of your horses. Now, after the fire, the marginal utility of horses is close to that of the cows. The cows probably still have more utility than the horses since you could possibly get by with just one horse for plowing, but you get the point. All this might seem pretty intuitive, and it is. But it’s amazing how many times the most intuitive things seem to elude us. This is most definitely true in regards to value theory. The idea of marginal utility finally solved many of the most pressing condundrums for economic thinkers around the turn of the century, 1900.
Critical listening on this subject:
The Marginalist Revolution: