Diminishing Marginal Utility

Diminishing Marginal Utility

Diminishing Marginal Utility (cont'd)The law helps to explain why more of a commodity is generally bought at lower prices. An individual's expenditure on different goods reflects his scale of preferences for them and his income. It follows from the law of diminishing marginal utility that total utility from the expenditure of a given income will reach its maximum when expenditure is distributed among goods and services so that a unit of expenditure (a penny or a pound) yields equal additional (marginal) utility from all of them, or more precisely (since prices of goods differ), so that relative marginal utilities are proportional to relative prices. If this were not so, total utility could be increased by redistributing expenditure until marginal utilities were equal (or proportional to price).

This is the condition of equilibrium for the individual. The equilibrium would be disturbed if the market price of one commodity were to fall say, while all others remain the same. The ratio of marginal utility to price would then, because of the fall in price, be greater for that commodity than for others. To restore equilibrium expenditure would have to be switched from other commodities until once again relative marginal utilities were everywhere proportional to relative prices. This 'substitution effect' of a change in the price of a commodity invariably tends to increase the purchases of a good when its price falls relative to others. The substitution effect is normally reinforced by the fact that a fall in the price of a commodity really increases the income of the consumer, i.e. the sane amount of it can now be bought with the sacrifice of less income. Since income has increased, consumers will tend to buy more of all goods, including the commodity in question. Normally this 'income effect' of a change in price is unlikely to be significant unless the price changes are large and the commodity bulks large in consumers' expenditure. When the commodity is an 'inferior' good, the income effect of a price change becomes important, since it may work in opposition to the substitution effect instead of reinforcing it, and, if strong enough, may outweigh it, thus leading the individual to buy less of a commodity when its price falls.

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