The other night my wife baked some brownies. After the anticipation that started as soon as she announced her plans, and grew steadily as we could all smell them baking, the first brownie was outstanding.
The second one was really good too. After that my wife said "take them away. Those were great but a third wouldn't be and I would only regret it".
A perfect real world example of diminishing marginal utility. The formal definition is:
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.
Or, more succinctly, you enjoy each additional brownie a little less than the one that came before it.
If we ate four brownies in short order and charted our enjoyment of each (the first one 10/10, the second 8/10, the third 5/10 and the fourth 1/10) it would look like this:
If we were to go into business selling fresh baked brownies (the "fresh baked" part is very important! If were were dealing with frozen brownies or brownie mix or catering baked goods for parties things would be very different) how would we respond to this? We want to sell as many brownies as possible but we know that each subsequent brownie offers the customer less pleasure (value).
Traditional cost-plus pricing would base the price of each brownie on its cost plus some specific amount (the "cost plus" part), potentially with some small volume or "good customer" discount for people purchasing multiple units. With cost-plus the pricing looks like this:
Knowing what we know about diminishing marginal utility we see that traditional cost-plus pricing does not help us sell more brownies. The price of the second brownie is already well out of line with the value it holds for the customer, and the price of each additional brownie is even less appealing.
With value based pricing our goal is to align pricing with the value the customer places in the product. The first brownie offers the greatest value, each additional brownie a little less, and ideally our pricing would reflect that. Ideally there would be the same area below both the "Enjoyment" and "Price" lines.
Realistically having four different prices for an item like this is a little complicated and unwieldy so it would be more practical to look at a "Buy X, Get Y" free type deal:
With this model we see that there is still a lot more area under our price line (orange) and the customer's value line (blue) meaning that we're still charging more than they would want to pay. The "free" fourth brownie holds some allure but overall this deal is probably not good enough to help us in our goal of getting people to buy a lot more brownies.
Plus - and we're getting into marketing territory here - there is a good chance four brownies is just more than most people want to deal with.
Here we're focussing on the more likely situation where a customer, with the right offer, could be persuaded to consider a total of three brownies.
Overall there is an almost identical amount of overall area under each of the enjoyment under both the enjoyment and price lines meaning that this is a good deal for both parties and one that will, hopefully, help us sell a lot more brownies by recognizing their diminishing marginal utility.
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