5 Important Theoretical Importance of the Law of Diminishing Marginal Utility

Thus, the fundamental applicability of the law is not violated. The law of diminishing marginal utility is of paramount importance. It is one of the basic laws of Economics and has practical as well as theoretical importance. This is discussed below:

(1) Basis of Law of Demand:

The law of demand is rooted in the law of diminishing marginal utility. The price which a consumer is prepared to pay for a commodity depends upon the marginal utility and not on the total utility. As the consumer purchases more and more units of the commodity, the marginal utility derived from that commodity steadily decreases.

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That is why he would like to buy additional units of the commodity only at a lower price. Thus, a consumer is ready to pay higher price for the initial units and lesser for the additional ones. This shows that the law of demand is based upon the law of diminishing marginal utility.

(2) Explanation of Diamond Water Paradox:

The law of diminishing marginal utility helps to resolve the ‘paradox of value’ posed by Adam Smith. According to the law of diminishing marginal utility, the price of a commodity is influenced by its marginal utility.

Since water is available in plentiful quantity, its marginal utility is low or even zero. Therefore, its price is very low, yet it is essential for human existence. On the other hand, diamond being a scarce commodity commands a higher price due to its higher marginal utility, though not essential for human existence.

The paradox of value can be explained with the help of a diagram. In Fig. 4.4, the marginal utility curves for diamond (MUD) and water (MUW) are shown as downward sloping linear curves. In this figure, MUW is lying above MUD curve, since consumer gets relatively higher marginal utility from initial units of water consumed by him due to its higher use – value.

Suppose, the quantity of diamond available is OQD and that of water is OQw Now, diamond will command a price of PD QD with total utility equal to OAPD QD. Water will command a price of Pw Qw with total utility equal to OBPw Qw.

Hence, the price a consumer would be willing to pay for diamond is high, but, it has lower total utility vis-a-vis water. On the other hand, the willingness price is very low for water, but larger total utility. Hence, price reflects marginal utility, while total utility determines the use – value of the commodity.

In the words of Samuelson, “The more there is of a commodity, the less becomes the relative desirability of its last little unit even though its total usefulness always grows as we get more of the commodity. So, it is obvious why a large amount of water has a low price. Or why air is actually a free good despite its vast usefulness. The later units pull down the market value of all units”.

Thus, the controversy of diamond water paradox is resolved through marginal and total utility analysis. It explains that the total utility of more useful things like water may be very high. It is impossible to give up using water altogether.

But, the marginal utility of water is negligible on account of its abundant supply in most of the places. If one bucket full of water is given after we have used as much as we required, it would have almost no utility. So, it commands a low price. On the other hand, diamond, whose total utility is presumably less than that of water, is notoriously expensive. If people had to do without diamond, there would be no suffering or inconvenience.

But, the utility of a single diamond is appreciable, since it’s one more or less unit can make considerable difference to our enjoyment due to its short supply. It is for this reason that diamond is highly valuable, while water is almost valueless.

In this way Marshall’s law explains the divergence between value-in-use and value- in-exchange. Commodities like water, air, light, etc. have greater utility (value-in-use), but, little value in-exchange because they have low marginal utility.

Fig. 4.4: Diamond Water Parodox

(3) Importance in Theory of Value:

The law has special significance in the determination of price. When the supply of commodity rises, its marginal utility falls. Therefore, price comes down as price is always equal to the marginal utility. Likewise, when the supply of a commodity falls, it’s marginal utility rises and hence prices will go up.

(4) Basis of Consumer Surplus:

The concept of consumer surplus is also based upon this law, discussed in details in a separate subsequent chapter. It is the excess of the price, which a consumer is willing to pay for the commodity over and above, what he actually pays for it.

We know on the basis of the law of diminishing utility that the consumer is ready to pay higher price for the initial units of the commodity and lower ones for successive units. So long as price actually paid is less than what a consumer is willing to pay, consumer surplus will rise, which will decrease for each successive unit of the commodity consumed by the consumer.

Consumer surplus will be equal to zero for the last unit consumed by him, since for this unit of the commodity, price actually paid by him equals marginal utility (price he is. willing to pay).

(5) Basis of Law of Equimarginal Utility:

The law of equimarginal utility explains the equilibrium of a consumer with the help of limited resources, such that marginal utility derived from each commodity is proportional to its price. The law of diminishing marginal utility provides foundation for the law of equimarginal utility and several other laws of consumption.