Total and Marginal Utility - thisMatter.com

Total utility is the total satisfaction received from consuming a given total quantity of a good or service, while marginal utility is the satisfaction gained ... thisMatter.com›EconomicsTotalAndMarginalUtilityWhyisthefearoflosingmoneyinaninvestmentgreaterthanthedesireofearningthesameamountofmoney?Why,assomestudieshaveshown,doesthedesireforgreaterincomedropoffsharplywhenapersonisalreadyearningatleast$75,000annually?Whywouldsomeonepayover$100millionforapaintingor$35,000forapurse?Whydoricherpeoplevalueexperiencesoveracquiringmoregoodsorservices?Ifapoorpersonearning$20,000ayearpays20%oftheirincomeintaxesandarichpersonmaking$1millionperyearpays90%oftheirincomeintaxes,whohasthegreatertaxburden?Youcangaininsightintotheanswerstothesequestionsbyunderstandingmarginalutility,especiallythemarginalutilityofmoney.Utilityisthesatisfactionapersonderivesfromtheconsumptionofagoodorservice.Totalutilityisthetotalsatisfactionreceivedfromconsumingagiventotalquantityofagoodorservice,whilemarginalutilityisthesatisfactiongainedfromconsuminganadditionalquantityofthatitem.Sometimes,economistsliketosubdivideutilityintoindividualunitsthattheycallutils.However,becauseutilityissubjective,meaningthatitdiffersfrompersontoperson,andbecauseitvariescontinuously,dependingonthequantityconsumed,anutilcannotactuallybemeasured,butissimplyaheuristicdevicethatallowseconomiststotalkaboutthedegreeofsatisfactionforaproductorservice.Marginalutilityalwaysdeclinesforeachsuccessivequantityofconsumption.Ifyoulikeicecream,andyoueatonescoop,thefirstscoopwillprovidethegreatestsatisfaction.Ifyoueatanotherscoop,you'llprobablyenjoythatalso,butthesatisfactionwillbelessthanforthefirst.Atsomepoint,youwillnotwantanymoreicecream.Themarginalutilitywilldroptozeroandmayevenbecomenegative.Thisillustratesthelawofdiminishingmarginalutility.Marginalutilitydeclinesforeverything,includingmoney.Althoughmanypeoplewanttoamassgreatwealth,eachdollaraccumulatedbecomesworthlessandless,becausethemarginalutilityofwhatitcanbuydeclines.QuantityMarginalUtilityTotalUtility11010281836244428523060307-228Ascanbeseeninthesediagrams,totalutilityincreaseswithincreasingquantityofasingleitemuntilmarginalutility=0;thereafter,totalutilitydeclineswhenmarginalutilitybecomesnegative.Apersonorfirmhaslimitedresources,sototalutilityismaximizedbyapportioningthoseresourcestoproductsandserviceswherethemarginalutilityofeachisequal.Intermsofmoney,ifbuyingagreaterquantityof1itemyieldsasmallermarginalutilitythanifthemoneywerespenttoacquireanotheritem,thentotalutilitywillbelessthanifthatotheritemwaspurchased.Thus,totalutilityismaximizedwhenthemarginalutilityofthelastdollarspentonanyproductorserviceequalsorexceedsthemarginalutilityofanyotherpurchasethatcouldhavebeenmade.Decliningmarginalutilityexplainswhythedemandcurveslopesdownwardasthesupplyquantityisincreased,andwhypeoplewillonlyconsumemoreifthepricedeclines,sincepeople'swillingnesstopayalsodeclines.Marginalutilityisalsorelatedtotheelasticityofdemand.Ifdemandisinelastic,thenthequantitydemandeddropsoffslowlyasthepriceincreases,indicatingthatthemarginalutilityoftheproductorserviceishigh;withelasticdemand,demandquantitydropsoffsharply,indicatingalowmarginalutilityfortheproduct,sotheconsumerisnotwillingtopayahigherprice.ConsumerChoiceConsumerchoiceisguidedbypreferencesforspecificproducts,budgetconstraints,prices,andthemarginalutilityofproducts.Abudgetconstraintexistsbecausetheconsumeronlyhassomuchmoney,soonlysomuchcanbespent;therefore,evenamongdesirablethings,achoicemustbemade.Thischoicewilldependonthemarginalutilityoftheproductanditsprice.Becausemarginalutilitydeclineswithquantity,whilethepricedoesnotvary,aconsumertendstobuyasmuchproductuntilthemarginalutilityoftheproductfallsbelowthemarginalutilityofotherproductstheconsumercanbuy.Hence,theconsumerstopsbuyingmoreofaproductwhenthemarginalutilityofanadditionalamountislessthanitsprice.Inthisway,thetotalutilityofwhattheconsumercanpurchasewithinhisbudgetismaximized.Sothemarginalutilityofeachtypeofproductdividedbyitspricewillroughlyequalthemarginalutilityoftheotherproductsthattheconsumerpurchaseddividedbytheirprices.Thisiscalledthelawofequalmarginalutilityperdollar,sincedollarsarespentforeachgoodorserviceuntilthemarginalutilityofeachgoodorserviceisequal.MarginalUtilityofProductAMarginalUtilityofProductB÷=÷PriceofProductAPriceofProductBIndifferenceCurveAnalysisHowconsumerchoicevarieswithmarginalutilityissometimesdepictedwithindifferencecurves.Eachpointonanindifferencecurverepresentsacombinationofproductsthatyieldsthesametotalutilityfortheconsumer.Becauseeachconsumer'spurchasingpowerislimited,thisbudgetconstraint,representedbyabudgetline,limitsthechoicesconsumersmake.Indifferencecurveanalysisissimplifiedbyassumingthattheconsumerspendsalltheirmoneyon2products.Forinstance,supposetheconsumerhas$12tospendoncantaloupesandapples.Eachcantaloupecosts$2apieceandeachapplecosts$1apiece.Thefollowingtableshowswhatcanbepurchased:ApplesCantaloupes0625446382101120Thisyieldstheabovebudgetline.Anindifferencecurveforthisexamplewouldyieldeverycombinationofapplesandcantaloupesthatyieldthesametotalutility.Indifferencecurvesareconvextotheoriginbecauseofthelawofdiminishingmarginalutility—whenthereisapredominanceofcantaloupes,thenthemarginalutilityofanadditionalcantaloupeislessthanthemarginalutilityofanadditionalapple,andviceversa.Inotherwords,consumerslikevariety.Atangentlinetoanindifferencecurverepresentsthemarginalrateofsubstitution(MRS)ofoneproductfortheotherthatmaintainstotalutility.Anindifferencemapcanbecreatedbyseveralindifferencecurvesrepresentinganincreasedbudgetforapplesandcantaloupesthatallowstheconsumertobuymoreofeachproductforagreatertotalutility.Generally,consumerswithhigherincomeswillhavelargerbudgetsforspecificitems.Intheabovediagram,forinstance,I1representstheindifferencecurveatthelowesttotalutilityofthe3displayedinthediagram.TheconsumerwouldnotchooseanypointonthiscurvebecausetheirhigherincomewiththecorrespondinglyincreasedbudgetforcantaloupesandappleswouldallowtheachievementofgreatertotalutilitybychoosingapointonindifferencecurveI2thatwouldstillbeaffordable.Whentheconsumer'sbudgetlineissuperimposedontheindifferencemap,thepointwherethebudgetlineistangenttothehighestindifferencecurveisthehighestattainabletotalutility,giventheconsumer'sbudget,andrepresentstheconsumer'sequilibriumposition.AlthoughcurveI3offershigherutility,thepriceofanycombinationofcantaloupesandapplesonthisindifferencecurveisoutsideoftheirbudget.ExplainingtheRealWorldUsingtheMarginalUtilityofMoneyThemarginalutilityofgoodsandservicesdirectlyaffectsthemarginalutilityofmoney,foriftheadditionalvalueofgoodsandservicesfalls,sodoesthemoneyusedtobuythoseitems.Marginalutilityexplainsalotinoureconomy,includingtheanswerstothequestionsposedatthebeginningofthisarticle.Whydoinvestorsfearlossmorethantheydesiregain?Investorsaremorefearfuloflosingmoneythantheirdesiretogainthesameamountofmoney,iftheprobabilityofthegainorlossisequal.Soifsomeonehas$100,000toinvest,wheretheinvestmentwillyield,witha50%probabilityperoption,eithera$50,000gainor$50,000loss,mostinvestors,especiallyrisk-averseinvestors,wouldforgotheinvestment,becausethelossofthe$50,000hasmorevalue—greatermarginalutility—thanthegainofanadditional$50,000,asshownintheaboveschematicdiagram.Ofcourse,ifthegainhadasufficientlygreaterprobability,thentheinvestorwillbemorelikelytoinvest.Howmuchmorelikelywoulddependontheperceivedprobabilityofthegainorlossandontheriskprofileoftheinvestor.Thus,themarginalutilityofmoneyexplainsriskaversion,sinceagivenamountoflossalwayshasagreatermarginalutilitythanthesameamountpotentiallygained.Thedesireforhigherincomedropsoffsignificantlyafter$100,000(thiswillincreasewithinflation)becausethemarginalutilityofmoneydeclinessignificantly.Inmostlocations,itisasufficientincometopayforadecentliving,whichiswhyotherthingsbecomemoreimportant,suchastimeoff.Apaintingisjustanarrayofcolorsonacanvas,earnsnoincome,costsmoneytostoreandinsure,sotheonlyhopeforprofitisifsomeoneelsewillpayevenmoreforitlater.Sowhywouldsomeonepay$100millionforapainting?Obviously,someonerichenoughtoaffordthefinestthingsinlife,sothemarginalutilityofthe$100milliontothebuyerissmall.Iftheinvestmentresultsinaloss,thenitisnotalossthatwouldhavemuchconsequenceforthebuyer.Afterall,noonewouldspend$100millionforapaintingifthatisalltheyhad!Italsoexplainswhyrichpeoplepay$35,000forapurseorover$1millionforcar.Ofcourse,manyrichpeopleliketoshowofftheirwealth;itishowtherichmeasurethemselvesamongthemselves—itrepresentstheirstatus.Forsomeonewhoonlyhas$35,000,theycertainlywouldnotuseittobuyapurse,sincemanyotherthingswillhavemuchgreatermarginalutility,includingfood,shelter,andhealthcare.Thepoorpersonneedsthemoneytobuyessentialgoodsandservices:food,shelter,healthinsurance,andsoon,andeventhewhole$20,000wouldnotcoverit.Ontheotherhand,therichpersonearning$1millionannuallystillhas$100,000afterpayingthe90%tax,whichstillallowshertobuyalltheseessentialnecessitiesoflife.Infact,herafter-taxincomewouldstillbealmosttwicethemedianhouseholdincome—beforetaxes!—intheUnitedStates(2015medianincome:$55,775),andatleast3timesmoreafterthataverageincomeistaxed.Ifsheonlypaidthe20%ratethatthepoorpersonpaid,thenshecouldbuyanicerhouse,anicercar,andmanyotherthings,buttheimprovementswouldhavelessmarginalutility.Althoughthemarginalutilitycannotbequantifiedinthesecases,it'snotunreasonabletoassumethatthepoorpersonpayinga20%ratehasamuchgreatertaxburdenthantherichpersonpayingthe90%rate,becausetherichpersoncanstilllivewell,evenifnotaswellasshecouldifshepaidthe20%rate.Somestudieshavefoundthatpeoplepreferspendingmoneyonexperiencesratherthangoods,whichseemsperplexing,sincegoodscanlastalongtime,whileexperiencesarefleeting.Arecentstudyhasshownthatmostpeoplevalueexperiencesmorethanbuyingmaterialgoods,butonlyiftheirincomeexceeds$25,000;otherwise,low-incomepeopleprefertobuymaterialgoods.Whatexplainsthis?Marginalutility,ofcourse.Themarginalutilityofproductsisgreaterwhenapersonhasfewerofthem,butastheaccumulationofgoodsincreases,themarginalutilityofadditionalgoodsdeclines,thusmakingexperiencesmoredesirable,especiallysincetherearemanymoreexperiencesthanthereareuniqueproducts.Moreover,peoplecanenjoytheirmemoriesofexperiences,especiallysincesuchenjoymentisenhancedbythefadingofboringorbadmemoriesandbytheembellishmentofgoodmemories,makingthememoriesbetterthantheactualexperiences.Theabovearenotcompleteexplanations,butmarginalutilitydoesprovideinsightintotheeconomicbehaviorofpeople.Themarginalutilityofmoneyshouldbeconsideredwhensettingtaxpolicy.Taxingthepoormeanstakingwhatlittletheyhavetopayforsurvivalmakesitmoredifficultforthemtosurvive,whichiswhytheyoftenneedgovernmenthandouts,whilehighertaxesonthewealthyaremuchlessburdensome.PersonalFinanceBankruptcyChapter7Chapter13Chapter11CreditandDebtDebtCollectionInsuranceTypesofInsuranceAutoHomeownerHealthLifeRealEstateTaxesIncomeTaxesPersonalDeductionsandTaxCreditsRetirementPlansGratuitousTransferTaxesEducationalTaxBenefitsTaxationofInvestmentsBusinessTaxesWills,Estates,andTrustsWillsandEstatesTrustsInvestmentsInvestmentFundamentalsInvestmentFundsMutualFundsLimitedPartnershipsBankingBondsTypesOfBondsGovernmentSecuritiesMoneyMarketInstrumentsCorporateBondsAssetBackedSecuritiesForexFuturesOptionsStocksStockIndexesStockValuationandFinancialRatiosTechnicalAnalysisEconomicsContactMe!SearchThisSiteUSSavingsIbondsarethebestinvestmentrightnow!Earnupto11.5%GUARANTEEDandWITHOUTRISK,freeofstateandlocaltaxes,and,ifusedtopayeducationalexpenses,freeoffederaltaxes!Althoughtheofficialrateis9.62%,thisvideowillshowyouhowyoucanearnupto11.5%!Howtoavoidfederaltaxeseveniftheproceedsarenotusedtopayforeducationalexpenses!CompareIbondstostocks.IBondsissuedinMay2000earneda259%return,asofApril2022,12%compoundedannually,withoutrisk!Bycontrast,theS&P500stocksonlyearneda106%returnoverthesametime,withlotsofrisk!Thisvideopresentsanin-depthoverviewofIbondsandhowtomaximizeyourinvestmentwithIbonds.