Advantages of the Law of Diminishing Marginal Utility
In social sciences, you often find that there is a wide gap between theories and their practical application. Have you ever thought why it happens? The answer is very simple. Almost all theories of social sciences are based on general human behavior and certain assumptions. Assumptions are necessary to hold the theory good. However, some of these assumptions are very unrealistic and do not work in all situations. In addition, it is hard to predict human behavior. Hence, theories that rely on such unrealistic assumptions and unpredictable human behavior fail to work in a real life scenario. Because of this reason, there is a wide gap between theories and their practical application. However, the law of diminishing marginal utility is completely different in this regard. Though the theory is derived from general human behavior, it possesses great practical importance. Let us see how the law of diminishing marginal utility is helpful in various fields of economics.
Basis for Progressive Taxation
The law of diminishing marginal utility is one of the fundamental principles in public finance. The law serves as the basis for progressive taxation. Adam Smith explained canons of taxation in his book ‘Wealth of Nations’. One of the canons of taxation is ‘Ability to Pay’. This means that taxes should be imposed according to the ability of people to pay. The law of diminishing marginal utility is crucial in determining people’s ability to pay. According to Prof. Pigou, the marginal utility of money for a poor person is higher than that for a rich person. This is so, because a poor person possesses little money; therefore, the utility derived from each unit of money is huge. This implies that rich people are able to pay more as taxes than poor people are. This concept leads to progressive taxation system, which imposes heavier tax burden on the rich. This is one of the very important practical applications of the law of diminishing marginal utility.
Redistribution of Income
Income distribution is the core concept in public finance. What the government does through taxation is taking away some of the resources from rich and spending them to improve the welfare of poor. Note that when a person possesses less money, the utility derived from it is huge. At the same time, when a person possesses more money, the utility derived from it is less because of the abundance. When taxes are imposed on rich, some of their money is taken away. Hence, the utility derived from the remaining money improves. At the same time, the money taken from the rich is spent to improve the welfare of poor. This implies that the poor becomes better off now. This activity helps to attain an egalitarian society. This process can be explained with the help of the following figure:
Let us suppose that there are two individuals (A and B) in a society. The poor man’s income is OA. OB’ is the rich man’s income. Suppose the government imposes tax on the rich; therefore, income of the rich is reduced by B’B. Now, the same amount of money income is transferred to the poor. This raises the poor man’s income by AA’. From the picture, you can understand that the marginal utility of the rich improves from D’ to D because of taxation. And the poor man’s utility declines from C to C’. This implies that money in the hands of the poor has increased. This activity leads to an egalitarian society.
Derivation of Demand Curve
The law of diminishing marginal utility is the basis to derive demand curve. The law further helps to understand why the demand curve slopes downward. Click here to know how to derive demand curve from the law of diminishing marginal utility. In addition, Go here to understand the relationship between the law of diminishing marginal utility and downward slope of a demand curve.
The law of diminishing marginal utility is helpful to determine the value or price of a commodity. For example, the law explains that the marginal utility of a commodity decreases as the quantity of it increases. When the marginal utility falls, consumers do not prefer to pay high price. Therefore, the seller has to reduce the price of the commodity, if he or she wants to sell more. In this way, the law plays a crucial role in determining price of a commodity.
Water – Diamond Paradox
The principle of diminishing marginal utility is beneficial to understand the difference between value-in-use and value-in-exchange. For instance, let us consider two commodities – water and diamond. Water is essential for our survival (value-in-use) but it is not costly (no or little value-in-exchange). On the contrary, diamonds are useful just for showy purpose (no value-in-use) but they are very costly (high value-in-exchange).
Water is abundant and hence has no marginal utility. Because of this reason, want has no or little value-in-exchange. On the contrary, diamonds are scarce and hence possess a very high marginal utility. Therefore, diamonds have high value-in-exchange. In this way, the law of diminishing marginal utility tells us why diamonds are highly priced when compared to water. This scenario is often referred to as water - diamond paradox.
The following diagram provides you with more information on this paradox:
In figure 2,
UU1 - marginal utility curve for diamond
VV1 - marginal utility curve for water
OA represents the supply of diamond
OF represents the supply of water
Since the quantity of diamonds is less (OA), the marginal utility derived from diamonds is high (AB). Therefore, diamonds are priced high (OC) as the price of a commodity is associated with its marginal utility. Let us look at the case of water. The quantity of water is high. Therefore, the marginal utility derived from water is less (FE). Because of small amount of marginal utility, water is priced less (OD).
Optimum Utilization of Expenditure
The law of diminishing marginal utility is useful for individuals to determine how much money should be spent on a particular commodity. The equilibrium point is where marginal utility is equal to price (point E in figure 3). At this point, we can say that the individual utilizes his or her expenditure optimally. Though we do not calculate all these things in our day-to-day purchasing activities, it happens naturally. We do not pay a high price for a commodity that does not give us utility. In this sense, the law of diminishing marginal utility does play an eminent role in all economic activities.
Basis for Economic Laws
Furthermore, the law of diminishing marginal utility serves as a basis for some important economic concepts such as law of demand, consumer’s surplus, law of substitution and elasticity of demand.
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© 2013 Sundaram Ponnusamy