Importance of the Law of Diminishing Marginal Utility

The law of diminishing marginal utility has great economic significance, theoretical as well as practical. From the theoretical point of view the law is important because, 

• The law explains the behaviour and the equilibrium condition of a rational consumer with respect to a single want and commodity. 

• The law of diminishing marginal utility is the basic law of economics. It provides the foundation for various laws of consumption. The law of demand is the outcome of the law of diminishing marginal utility. The law of demand states that larger quantities are purchased at a lower price. The reason is that as more units of a commodity are purchased its marginal utility to the consumer becomes less and less and so he gives lesser importance to additional units of a commodity. Therefore, he will buy additional units of a commodity only at a lower price. 

• The law explains the paradox of value. The value-in-use and value-in-exchange for a commodity are different. Diamonds have great value-in-exchange, as they are scarce in supply, they have greater marginal utility, and therefore, value is high. On the other hand, water is in abundant supply and its marginal utility is very low. Therefore, it commands no price even though its total utility is high. Thus water has great value in use but no value in exchange. Diamonds have great value in exchange though they are less useful than water. The price of a commodity is thus, related to its marginal utility. 

• Prof. Marshall has built up his theory of taxation and public expenditure on the basis of the law of diminishing marginal utility. The principle of progression has been deduced in the theory of taxation by the application of this law, to money. Further, it is argued that there should be equitable distribution of wealth because the utility derived by the rich from money is much less than what could accrue to the poor. If Rs. 100 deducted from the rich man’s income, means only a small sacrifice of comparatively little utility, while the addition to the amount to the poor man’s income, will increase his satisfaction by more than what a rich man has lost, therefore, methods should be devised to redistribute the national income on a more equitable basis.

The law has the following practical significance as well; 

• To the producer, the law serves as a guide to promote sales by reducing prices. Because, when the price falls, to attain equilibrium the consumer has to decrease the marginal utility to that extent. To do this he has to purchase more goods as the marginal utility diminishes only when the stock increases. 

• The law is useful to the finance minister in formulating an appropriate tax policy. He can justify progressive taxation on higher income on the ground that rich people will feel relatively lesser impact of the tax burden as the marginal utility of money is lower with the increase in income. 

• Similarly socialists can agitate for a redistribution of wealth to promote welfare on the ground that the transfer will cause more gain to the poor and less sacrifice to the rich.

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)