key term - Law of diminishing marginal utility

Definition

The law of diminishing marginal utility states that as an individual consumes more units of a good or service, the additional satisfaction (or utility) gained from each successive unit tends to decrease. This principle helps to explain consumer behavior and how individuals make choices based on the perceived value of goods, especially in relation to income and substitution effects when prices change or when consumers adjust their consumption patterns.

5 Must Know Facts For Your Next Test

1. The law of diminishing marginal utility implies that consumers will allocate their spending towards goods that provide the highest utility per dollar spent.
2. When the price of a good decreases, the substitution effect encourages consumers to purchase more of that good because its relative value increases compared to other goods.
3. As consumption increases, consumers may experience lower satisfaction from additional units, leading them to diversify their consumption instead of focusing solely on one good.
4. This concept is essential for understanding demand curves, as it helps explain why demand typically decreases as prices rise.
5. The law of diminishing marginal utility supports the rationale behind progressive taxation, where higher income individuals may benefit less from an additional dollar compared to lower income individuals.

Review Questions

• How does the law of diminishing marginal utility influence consumer choices when prices change?
  • When prices change, the law of diminishing marginal utility influences consumer choices by altering the perceived value of goods. If the price of a good decreases, consumers are likely to buy more of it since each additional unit offers less satisfaction than the previous ones, but it becomes a better deal relative to other goods. This shift can lead to increased demand for that good while potentially decreasing the quantity demanded for substitutes.
• Discuss the relationship between the law of diminishing marginal utility and the substitution effect in consumer behavior.
  • The law of diminishing marginal utility and the substitution effect are closely linked in explaining consumer behavior. As a consumer consumes more units of a good, the satisfaction from each additional unit decreases. When the price of this good drops, the substitution effect comes into play, encouraging consumers to substitute away from relatively more expensive goods to this cheaper one. This interplay helps determine overall consumption patterns and adjustments in demand.
• Evaluate how the law of diminishing marginal utility can inform policy decisions regarding taxation and public spending.
  • The law of diminishing marginal utility suggests that individuals derive less additional satisfaction from each extra dollar they earn as their income increases. This insight can guide policymakers in designing tax systems and public spending programs. For example, progressive taxation may be justified because higher-income individuals are likely to experience diminishing returns on additional income, suggesting that taxing them at higher rates may have a minimal impact on their overall utility while providing essential funding for public goods that benefit society as a whole.

Related terms

Marginal Utility:

The additional satisfaction or benefit gained from consuming one more unit of a good or service.

Total Utility: The overall satisfaction or benefit derived from consuming a certain quantity of goods or services.

Substitution Effect:

The change in quantity demanded of a good that results from a change in its price, making it more or less attractive compared to substitute goods.