Marginal Utility in Neoclassical Economics

The concept of marginal utility arose as rejection of the labor theory of value that had previously been espoused by neoclassical economists. Economists such as Adam Smith taught that the classical labor theory of value argued that the value – or utility – of a commodity was determined by three important factors that went into a product’s creation: the amount of labor that went into producing it, the effort required of the labor, and/or the amount of labor expected of others in exchange of the product. With the turn of the 19th century, this economic theory was challenged by other schools of thought that believed that there were many ignored factors that determined the utility of a product, mainly the marginal utility theorists.

Marginal utility

The marginal utility theory first and foremost sought to explore how the addition of an extra unit of a product influenced the original utility that a consumer derived from the item. In economic terms, “utility” is often viewed in monetary terms to give the value of a product real meaning. But theoretically speaking, utility is defined as being any abstract sense of worth, value, benefit, or satisfaction received from the product. Utility or value is always understood by economists within the context of the scarce global economy: even with humanity’s technological advancements and triumphs, scarcity of resources to eat, drink, and enjoy are what have human’s competing against one another in the marketplace. Utility enjoyed by a customer is influenced by their demand or need for the product, as well as the accessibility of it being supplied. Indeed, higher total utility is partially rooted in self-gratification and indulgence.

Marginal utility theory did not make assumptions of what individuals valued or got the most utility out of. What these economists sought to investigate was how a person’s total utility related to their level of consumption of the product. Marginal utility theory agreed that a consumer would derive additional satisfaction from every additional unit of a product they consumed or enjoyed. The idea of marginal utility understood that the demand for a product in the market is not determined by the total utility of a single unit of the product. What it explored was the ideal threshold of utility that can be received from additional units of an individual product. In other words, although total utility increases with every extra unit of a product, its marginal utility works inversely by decreasing with additional consumption. Marginal utility theorists subscribe to the idea of the law of diminishing marginal utility, more commonly known as the law of diminishing returns.

Take a nice Sundae ice cream, for example. Say you enter a store with a sweet tooth ready to devour a massive Sundae. With the first Sundae ice cream, your glucose levels, your total utility, and your marginal utility will be high because you received a massive amount of value for your money. You could call it a day at this point, but you got so much utility from devouring this treat that you choose to order another Sundae. And another one. And then another one. With every Sundae, your total utility increases, but your marginal utility decreases. The reason for this is because you get less satisfaction after reaching a threshold, either because you lose your appetite from eating, your teeth starting paining from the sweetness, or you start feeling ill. The law of diminishing returns helps navigate economists and producers alike as to what the ideal threshold should be as it concerns marginal utility. It is important to determine the point in where marginal utility remains high as to maximize profits, while also determining at what point of consumption, it actually becomes a negative or has diminishing utility. The marginal utility theory believes in one creed: “Less is more.” Less consumption signifies higher satisfaction which, in turn, reflects higher marginal utility and a greater willingness to pay more to achieve this higher marginal utility. Thus, understanding the idea of marginal and diminishing utility is important when determining prices, when choosing what to sell, what to buy, and how to provide the greatest utility to consumers so they’re willing to spend more.

In this way, neoclassical economics was the perfect complement to the idea of marginal utility. The role of marginal utility in neoclassical economics was rooted in the belief that individuals determined the value or utility of a product based on their consumption. Neoclassical economics stressed individualism in the market place: neoclassical economists such as William Stanley Jevons believed that the economy functioned because individuals were self-interested. A successful economy required more options for people to satisfy this self-interest. Neoclassical economists assumed that individual were ‘rational’ insofar that they sought to maximize utility or profit in their daily life while avoiding anything that may compromise maximum utility. Marginal utility plays an important role for neoclassical economists in understanding supply and demand pricing, as well as behavior by consumers. Prices lower with increased demand because of diminished utility with each additional unit limits sellers pricing options. Marginal utility influences the limits of customer’s decisions to allocate their money and in what bulk. Because of this rational understanding of individuals in the market, marginal utility and neoclassical economics are inextricably intertwined.