In economics, the law of diminishing marginal utility is one of the most important principles of economic theory. In economics, utility is a satisfaction or profit derived from the consumption of a particular commodity; so the diminishing marginal utility of an object or item is the decreasing amount of utility in relation to the increase in its consumption. The law of diminishing marginal utility describes a series of phenomena and principles that can be observed in a variety of situations in all industries.
The principle of diminishing marginal utility describes the process of decreasing the level of utility with the increase of consumption. It is based on the theory of demand and supply. The concept of utility maximization states that a consumer will not pay for a service or product that is beyond the level of his consumption. The principle of diminishing marginal utility applies in all types of situations.
The first condition that the law of diminishing marginal utility describes is that the value of a commodity is fixed; that is, it has no elastic value. The second condition is that the price of a commodity is constant. This condition refers to the existence of fixed or unchanging prices for commodities. The third condition is that consumers have a preference for a certain quantity of goods over another. The fourth condition is that consumers are willing to pay a certain amount for a certain commodity, so long as this commodity is offered at a lower cost than some other commodities.
The principle of diminishing marginal utility can be seen in any industry where there are two competing goods or services. One commodity is produced at a high rate but is sold at a lower rate than the other commodity. If the market were free, consumers would choose to buy the commodity at its highest rate, and then they would sell the commodity at its lowest rate. The law of diminishing marginal utility describes this situation and shows how it is possible for prices to reach their optimum level only to decrease below this optimum level.
The law of diminishing marginal utility also explains the concept of economies of scale in the production of products and services. When the production of commodities is limited in size, the level of production of the good or services required for a given quantity of production is increased in order to meet the demands of the consuming public. As time passes, the production of these commodities becomes very large and so the price per unit increases as the supply is increased.
Another principle of diminishing marginal utility is called the Law of Diminishing Returns. This concept states that as the production of a commodity increases, the level of the demand of that commodity decreases. The principle states that consumers will buy less of the good if the demand increases. This principle is illustrated when the production of the good or services required to produce a particular commodity increases, the demand for that commodity also increases; so that the cost per unit decreases.
The Law of Diminishing Returns is a general rule in all industries; however, it is more common in industries that require the use of specialized goods or services. A general rule for this type of industry is that the supply of the good is always greater than the demand for that specific good, even though the demand for that specific good may increase. When a particular product is required in large quantities, the price charged per unit decreases as the supply increases. In a general rule of diminishing returns, the supply and demand of the good or services are not directly related; therefore, there is no way to calculate a minimum price per unit in such industries as medicine, food, and clothing.
Disregarding these principles, the consumer will continue to pay more for every unit of product produced if the demand is constant; but, as the demand decreases, the supply increases and prices also increase. Thus, in most cases, a business will incur a loss because of the increasing costs of production and the decreasing level of demand.