Diminishing Marginal Utility

The law of diminishing marginal utility states that as a person increases consumption of a product - while keeping consumption of other products constant - there is a decline in the marginal utility that person derives from consuming each additional unit of that product.

One example might be a bag of popcorn at a movie theatre. The first few mouthfuls will likely provide the greatest utility (in this case pleasure) while each subsequent mouthful will provide us with diminishing marginal utility – a little less pleasure than the one that came before it.

Something like gasoline is very different – we don't savour the last mile any less than the first. We need enough fuel to get to our destination, and it is safe to assume that there will always be another destination and more demand in the future.

The chart below illustrates how the marginal utility of gasoline (the orange line) does not diminish while the enjoyment of movie popcorn (the teal line) diminishes rapidly.

Diminishing marginal utility plays a vital role when we go beyond a simple cost plus pricing formula. Instead of a strict correlation between quantity and price we recognize that in many cases the consumer will receive less utility (benefit) from additional units and subsequently values them less. We respond by discounting the additional units to increase consumption.

This is why the gas station does not aggressively discount larger gasoline purchases. In fact they don't discount at all. The utility of their product does not diminish.

It also explains why the per-unit cost of a large bag of movie theatre popcorn is drastically less than the per-unit cost of a small bag - the vendor is trying to convince you to buy more even though they know you will enjoy it less. The goal is to have pricing that reflects the value that the customer places on the product as shown in the chart below.

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