Diminishing Marginal Utility in Simple Terms
Diminishing marginal utility is a complicated-sounding economics term that’s worth adding to your business glossary. Basically, utility is used to measure customer satisfaction and preferences. Diminishing marginal utility is when a customer becomes less satisfied with a business or product with each interaction they have with them/it.
The law of diminishing marginal utility explains that as a person consumes an item or a product, the utility (benefit or use) that they get from the product decreases as they consume more of it [1]. It’s like when the commodity of a product wears out, or when you buy too much of something and it’s no longer useful.
For example, a customer might buy a certain scented candle because they love how it smells. Then the more they use the candle, they like its scent less and less, or become indifferent to it. That is diminishing marginal utility.
Marginal utility definition and examples
Marginal utility, also known as marginal benefit, measures the base level of satisfaction that customers receive from the consumption of goods. Marginal utility can be either zero, positive, negative, diminishing, or increasing.
- Zero marginal utility is when consuming more of an item brings no extra measure of satisfaction. For example, having two identical websites for your business won’t provide any more utility than having one.
- Positive marginal utility occurs when the consumption of an additional item increases the total utility. For example, if you need to buy three coffees in order to get a fourth for free, getting your third coffee is more exciting than buying your first and second.
- Negative marginal utility is when continued consumption causes a negative reaction among customers. Say if customers were to have a third piece of chocolate instead of two, and the third piece made them feel sick.
- Diminishing marginal utility is when the value decreases as customers consume more and more of the product or service and satisfaction levels go down. If you’ve just finished running, taking a gulp of water feels great. The second gulp is good, but satisfaction levels aren’t as high as they were the first time.
- Increasing marginal utility is when the value increases as exposure increases. There is greater satisfaction in finding the second shoe than there was in finding the first, since the second shoe gives you a complete pair of shoes [2].
How to measure marginal utility
Utility explains how much an individual is willing to pay for a good or service - how valuable they think it is. Marginal utility is worked out by dividing the total utility (price value) change by the change in the quantity of goods purchased over two or more visits/uses by a customer.
Marginal utility = total utility difference / quantity of goods difference
You can figure out these values by following the steps below. We’ll give an example to explain this better afterwards.
- Step one: Find the total utility of the first event.
How much a customer would be willing to pay to access a certain number of goods for the first time.
- Step two: Find the total utility of the second event.
Would they pay the same price, more, or less, to access the products for a second time?
- Step three: Find the difference between both events.
Work out the difference in how much they’re willing to pay the first and second time. This reveals the total utility difference.
- Step four: Find the difference between the number of goods purchased between both events.
Work out how much of the product they bought the first time versus the second time. Subtract the totals from each other to find the quantity of goods difference.
- Step five: Apply the formula.
With both final differences found, divide both differences and set them equal to marginal utility.
Example
You’re passing a shop on a hot day. A bottle of water costs $2, but because you’re so thirsty, you’re willing to pay $5 for one. Even though the bottles of water are only worth two dollars each, you place a utility worth of $5. You buy two bottles.
After drinking one bottle, your thirst is quenched, and now you’re only willing to pay $3 for the second bottle, placing a lower utility upon it.
To find the total utility for the first event, add both totals together:
Total utility: $5 + $3 = $8
The total utility for the first event is $8 for two bottles of water.
You visit the shop the following week and decide you want five bottles of water this time. After paying $5 for the first bottle, you think the second bottle is only worth $4 since you’re no longer as thirsty. You then decide you’d only pay $1 for the other three bottles since you can drink them later and you’re not thirsty at all any more.
To find the total utility in the second visit, add your purchases together:
Total utility = $5 + $4 + $1 + $1 + $1 = $12
The total utility for the second event is $12 for five bottles of water.
To find marginal utility, find the difference between both visits.
Total utility difference = $12 - $8 = $4
Next, to find the quantity of goods difference, subtract the number of bottles of water from each visit from each other:
Quantity of goods difference = 5 - 2 = 3
With this information in hand, apply the formula:
Marginal utility = total utility difference / quantity of goods difference
Marginal utility = 4 / 3 = 1.333
Marginal utility = $1.33 per bottle of water
The benefits of tracking diminishing marginal utility
First and foremost, understanding marginal utility can help you analyse the reasons behind your customers’ engagement and shopping habits. Using this information, you can make adjustments that appeal to their preferences, maximise your profits, and boost customer retention.
You can use diminishing marginal utility to keep customers happy by offering products that are more in line with what they want, at the prices they want. If you notice a decline in sales, calculate marginal utility to identify exactly what’s going wrong. Figure out whether your products are no longer meeting the needs and wants of a few random customers, or if it’s a full demographic.
Use diminishing marginal utility information in all aspects of your business. Use it to make more informed business decisions:
- Decide which products you should spotlight in a promotion or sale
- Determine the strength of your current marketing strategy
- Review how effective your branding is
- Rethink the accuracy of your pricing plan
Businesses should keep track of their recurring sales and customer retention levels to measure the satisfaction customers have from buying their goods. If a certain item stops selling, you can assume that customers are losing interest in that product and act accordingly.
Simplify customer relationship management with a reliable POS system
Customer satisfaction is the key to a successful business, but the guesswork involved can make it stressful and time-consuming. By choosing the right customer relationship management software for your small business, you can turn your attention to other areas of your business, like operational efficiency and finance.
Let your point of sale (POS) system handle things like sales trends, customer profiles, and loyalty programmes. Epos Now offers state-of-the-art POS systems for businesses in various industries. We let you choose the tools and insights to help your business achieve its goals. You can do everything from process transactions and print receipts to take inventory and manage staff.
With Epos Now, you can also:
- Create personalised email communications using set templates
- Schedule emails and SMS messages to be sent at the most impactful time of day
- Review analytics on engagement with your website and outreach
- Review profitability reports based on individual product performance, trending items, best and worst sellers, and employee sales
- View sales analyses on profit margin, cash flow, and other expenses
- Access multi-award-winning inventory management systems that sync online sales and in-person sales for the most up-to-date stock levels
- Automate stock purchasing so you never miss a sales opportunity
- Save customer contact details and shopping preferences for more targeted marketing on our CRM system
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- Simplify employee management for more efficient scheduling and payroll