Explain the law of diminishing marginal utility.

Law of Diminishing Marginal Utility

The Law of Diminishing Marginal Utility states that as a consumer consumes successive units of a commodity, keeping the consumption of other commodities constant, the additional satisfaction (marginal utility) derived from each additional unit decreases.

Statement

"Other things being equal, the marginal utility of a commodity diminishes as the quantity consumed increases."

Assumptions

1. Constant Utility Scale: The unit of measuring utility (utils) remains constant.
2. Homogeneous Commodity: The commodity consumed is identical in quality and quantity.
3. Continuous Consumption: The consumer consumes the commodity continuously without breaks.
4. No Change in Income or Prices: The consumer's income and the prices of other goods remain unchanged.
5. Rational Consumer: The consumer aims to maximize total satisfaction.

Explanation with Numerical Example

Consider a consumer drinking glasses of water. As thirst is quenched, the satisfaction from each additional glass decreases.

• Unit 1: High satisfaction (10 utils) because thirst is high.
• Unit 2: Satisfaction drops to 8 utils.
• Unit 6: Marginal utility becomes zero (satiation point).
• Unit 7: Marginal utility becomes negative (disutility).

Graphical Representation

Significance

1. Basis of Demand Curve: It explains why the demand curve slopes downward from left to right. As price falls, consumers buy more, but only because the marginal utility of additional units is lower.
2. Consumer Equilibrium: It helps in determining the optimal allocation of income between different goods where $\frac{M{U}_x}{P_x}=\frac{M{U}_y}{P_y}$.
3. Taxation Policy: Governments use this law to design progressive tax systems, where higher income earners pay a higher marginal rate, as the marginal utility of money decreases with income.

Limitations

1. Non-Quantifiable Utility: Utility is subjective and cannot be measured in exact units.
2. Assumption of Homogeneity: Real-world goods often vary in quality.
3. Habit Formation: For some goods (like tea or cigarettes), marginal utility may increase initially due to habit formation.
4. Complementary Goods: The law does not hold strictly for complementary goods (e.g., left and right shoes) where utility increases with pairs.