The Wonder of Marginal Utility

In the personal finance world we tend to gush over things like compound interest saying how great it is  and how if you start early in saving it will do wonders.  While this is true the heavily under rated concept of marginal utility will likely help you almost as much as compound interest if you understand it and apply it correctly.

So what the hell is marginal utility?  Well you can read the entire Wikipedia entry here, but I shall summarize it briefly here: it’s the declining usefulness of obtaining more of something.  So let’s say you get a unit of water every day (perhaps 2L).  That first two litres of water lets you live, so it is highly useful to you.  Then you get two units of water a day, well now you can also do some cleaning on yourself so again it is useful, but not as much as keeping you alive.  Then by 120th unit of water a day, you don’t get anywhere near the same value you did out of first two units, but this point you are flushing an ounce of piss away because you have nothing better to do with that unit of water.

Basically a lot of things in your life fall under the concept of marginal utility, electronics being perhaps the most obvious one.  Not having a cell phone to having a cell phone can be a big jump in usefulness in people’s lives.  Yet upgrading from an iPhone 4 to an iPhone 4S will give you almost no additional feature that you already use, so basically as an investing from a marginal utility point of view the upgrade is basically nearly pointless or brutally expensive for some very minor features.

Now you can also expand this concept to just about everything you use in life.  That first steak you buy in the summer and put on the BBQ will likely have a high degree of marginal utility, but from there it drops off.  So what does this mean?  Well to get the most out of your spending in life you focus on buying the first few units of everything and then forget about the rest.  Enjoy that first glass a wine with your supper, but don’t bother getting drunk…you won’t even really taste the wine at that point.

So the lesson from this? If you do excessive consumer spending it is entirely possible to hack that spending down hugely yet notice a very minimal difference in you daily life.  You will still eat, you will still enjoy the odd luxury, but you won’t be wasting your money nearly as much.  Your first $20,000 of spending will be very useful to you, but by $80,000 per year you are chasing diminishing returns on your investment.  You life will not in fact be four times better than if you spend only $20,000 per year.

So do you ever think about marginal utility in your life?  What are some other areas where you have noticed this concept applies?

7 thoughts on “The Wonder of Marginal Utility”

  1. I disagree somewhat with the wiki definition you paraphrased. (I recall learning about marginal utility when I first took some economics classes 30 years ago; I would eventually major in it.) MU is simply the change in utility, positive or negative, from an incremental addition of the item. The MU curves I saw in my econ textbook were shaped like an upside-down U, sloping upward, leveling off, then sloping downward. This means there is some increase in MU at the beginning before it later declines.

    A real-life example of this was when I began working full-time and earned enough money to get my own place and live on my own. Those first several thousand of dollars of wages increased my MU (after the first few hndred dollars of wages) before it would eventually level off.

  2. M,

    Not a bad point for my water example, but how do you store happiness?

    Deegee,

    True it can slope upwards as in the case of earning raises…I was focusing on the negative curve in this post. I should have made that clear. Thanks for pointing that out.

    Tim

  3. It seems a lot of people are grappling with the notion of value here:

    “how do you store happiness”

    “shaped like an upside-down U, sloping upward, leveling off, then sloping downward”

    The article states what I have observed for myself:

    “Not having a cell phone to having a cell phone can be a big jump in usefulness in people’s lives. Yet upgrading from an iPhone 4 to an iPhone 4S will give you almost no additional feature that you already use”

    But I think we should consider the human element in this. If we go to Von Mises’s “Human Action”, he asserts that value is completely subjective and his concept of praxeology is based on human action to better one’s condition … where the notion of “better” is simply as viewed by an individual.

    To some people I’d say having the 4S over 4 for a phone might legitimately be worth the price in their mind even relative to not having one at all if having “the latest” is valued very highly. The only way to alter this reality is to try to convince others of an alternative system of valuing things.

  4. Hotels is a good example – if you’re just sleeping there, what does it matter where you stay? (As long as there isn’t insects.) OTOH, I will spring for a balcony cabin on a cruise with kids because that IS worth it to me.

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