Diminishing Marginal Utility

The law of diminishing marginal utility

Not to be confused with the law of diminishing returns, the law of diminishing marginal utility is an economic concept that is super useful for thinking about your everyday spending. The law states that, past a certain point, an increase in the use of a product doesn’t bring an increase in utility. In fact, each subsequent use leads to less overall satisfaction. Basically, more stuff doesn’t lead to more happiness once your needs are met.

I’ll start with a few examples to get you familiar with concept, and then look at consciously applying the law to your decisions in life. Diminishing marginal utility sounds complicated, but it’s actually a pretty simple concept. And the rewards of paying attention to this are immense.

A real world example of diminishing marginal utility

Let’s look at an object that practically everyone either has in their pocket, bag or is holding in their hands at this moment. It’s a $1,500,000,000 a year industry. Yep, your smartphone.

That phone is a great thing – it does a lot of things! But what happens if you buy a second cellphone? Maybe a second is useful as a backup, it provides some utility, but much less than the first one. A third cellphone provides almost no additional utility besides a little more redundancy. A fourth phone is totally useless – it provides absolutely nothing beyond what the first two or three already supply.

Sometimes additional units continue to add utility, but at an increasingly lower rate

I have a digital SLR camera, and I frequently drool over all of the available lenses. There are hundreds of lenses that fit on the camera, and arguably most of lense do something unique that the other lenses do not. Even if you ignore all of the lenses that are similar, there are dozens of choices a photographer could find a use for.

So let’s look at what happens as I buy additional lenses. The first provides the most utility, without at least one lense the camera is just a useless lump of plastic. The second could be something with a specific use, perhaps a zoom lense. The second lense provides unique utility, but not as much overall utility as the first lense.

A third lense is still useful, but less so than the second and much less than the first. I could arguably find a use for a fourth, fifth, sixth, seventh, eighth… But each subsequent lense provides less utility than the previous. At some point additional lenses would provide almost no additional utility to me.

When additional units subtract utility

Let’s look at coffee. As a slight caffeine addict, that first cup when I get up in the morning is almost crucial. Perhaps I’ll have another, thank you. But that second cup is just not quite as good as the first. The third cup still tastes pretty good, but it comes with a caffeine headache and subsequent afternoon crash. I’d have been better off not drinking it, the cost is higher than the reward, its utility is negative.

Utility

I should probably define utility for the purpose of this article. Utility is the usefulness of something. It’s a measurement of how much benefit is provided by that good or service or experience.

Diminishing utility not just about stuff

The same phenomenon is true for experiences and services as well.

The first time you go out to eat at a great restaurant is a magically choreographed performance with excellent food and perfect service. If you go back the very next night, your perception of the experience won’t be quite as high as the first time around even though the food and the service are the same. Go back on the third night and you’ll no longer be surprised by anything. By the fourth the experience begins to feel normal, all of the magic is gone. By the fifth night in a row fatigue starts to set in.

The diminishing utility of increasing income

As you climb the income ladder each additional dollar provides less utility than the previous dollar. For someone working a minimum wage job getting a $1 an hour raise is significant. But for someone making the much higher US median wage that same $1 an hour doesn’t change their overall financial situation by a whole lot. And for a high level executive at the top of the earning curve $1 is unnoticeable.

Use this

This is a very simple concept with a complicated name. By defining it, we are better able to think and talk about it. Just slapping a name to idea is enough to become conscious of what’s going on and to start making changes.

You can think of your own examples where the benefit, or utility, diminishes with increasing use or consumption. We know that our level of satisfaction per unit decreases as utility diminishes, yet our tendency is to dump an increasing amount of resources into the equation in an attempt to derive the same level of satisfaction per unit as we originally had. What if instead we simply move on to other things?

Pay attention and you can actually increase the overall amount of utility derived in your life without using more of your resources. Especially in the case of experiences, we can defer and actually derive more happiness from the same amount of spent resources.

Think again about the example of eating out at the same fancy restaurant five nights in a row. Each subsequent night returns less utility than the previous with the same expenditure of resources. To maintain the same level of satisfaction as that first night you would have to go to increasingly fancier restaurants each night, at an increasing expenditure of resources.

But what if instead you defer the experience? Instead of going out to a nice restaurant five nights in a row, look what happens if you spread the experiences out over a longer term. You have a great experience on night one. Instead of chasing the dragon and going back the very next night you decide to wait. With time your memory fades a bit, your baseline expectations lower, going out to eat is again an exciting prospect. When you do go back months later it will be just like the first time around – a high level of utility.

Make better purchases

A truly rational consumer makes calculated decisions. But of course, as humans we’re not really all that rational. But if you try to approach potential purchases with logic instead of emotions, you’ll gain a higher level of utility and greater overall satisfaction.

It’s a hard thing to do as the emotional part of our brain is in control most of the time. I have to constantly remind myself to think about what’s going on, and wrestle the controls from the instant gratification seeking emotional side of myself. It doesn’t come naturally and it takes a lot of practice.

But by exercising the rational side I’ve slowly gotten better at making these decisions. Over the last few years I’ve been focusing more on maximising utility and thus far the results are pretty significant – I’ve actually reached a higher overall level of satisfaction with less total input.

I’ll say that again, I’m happier overall spending less money and time since my expenditures are focused on the things, experiences and services that actually matter to me. I would never have believed this increase in baseline happiness was achievable before trying it for myself.

Another definition of the law of diminishing marginal utility

As stolen from investopedia, since their definition is short and simple. The law of diminishing marginal utility:

The more you consume a good or use a service, the less satisfied you will be with each successive use or consumption.

Or, there really is such a thing as too much of a good thing.

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