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Diminishing Marginal Utility

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This article is part of the Basic Liberalism Course -> Module 5: Notions of Austrian Economics

Last updated: 2026-05-02

Definition

Marginal utility is one of the most revolutionary concepts of the Austrian School; it is the concept that revolutionized economics by solving the old "paradox of value" (why water, being vital, is cheap, while diamonds, being dispensable, are expensive).

Unlike other currents, Austrians emphasize that utility is not something that can be measured in numbers (as if they were "units of pleasure"), but rather it is a subjective scale of preferences.

Marginal utility = the satisfaction (or value) that the individual attributes to the last unit of a good that he possesses or is considering acquiring.

1. The Law of Diminishing Marginal Utility

Carl Menger, founder of the Austrian School, established that:

  • The greater the quantity of a good that a person already possesses, the lower the subjective utility that he assigns to each additional unit (one more) of the same good.
  • As an individual possesses more units of an identical good, the value that he assigns to each additional unit is lower.

This happens because the human being is a being that acts to satisfy ends. When he has the first unit of a good, he allocates it to his most urgent need. The second unit is allocated to the next need on his list of priorities, and so on.

Classic example (The settler and his sacks of wheat): Imagine a farmer who harvests 5 sacks of wheat:

  1. The 1st sack he uses so as not to starve (life).
  2. The 2nd to strengthen himself (health).
  3. The 3rd to feed his animals and have meat (protein).
  4. The 4th to make whisky (leisure).
  5. The 5th to feed his parrots (pure aesthetic pleasure).

If the farmer loses a sack, he will not stop eating; he will simply stop feeding his parrots. Therefore, the value of any sack of wheat is equal to the value of the least important end (the 5th).

2. Value is Subjective and Ordinal

Historically, utility began as cardinal (it was thought that it could be measured in units or "utils"). For Austrians, utility is not cardinal (you cannot say "this gives me 10 points of utility/satisfaction/emotion/pleasure"), but ordinal (you can say "I prefer A over B").

  • Subjective:

    • It depends entirely on the individual's valuation at a specific moment and context. Water has low marginal utility in the city, but extremely high marginal utility if you are lost in the desert.

  • Ordinal:

    • Utility is not measured in cardinal units.
    • Only the order of preference matters: the individual prefers an additional unit of a good less than the previous unit in his subjective scale of values.
    • That is: the first unit of water in the desert is worth more than the second, the second more than the third, etc., but we cannot say "it is worth exactly double" or "it is worth 15 units". We only know the ranking.

  • Marginal:

    • It refers to the unit that is "at the margin", that is, the unit that the individual is considering acquiring or from which he must part.

3. The Solution to the Paradox of Value

The Austrian School (with Carl Menger at the head) explained that the price of goods does not depend on their "total" utility for humanity, but on their marginal utility.

  • Since water is abundant, the "marginal unit" of water is used for very unimportant ends (washing the car, watering the lawn). That is why its price is low.
  • Since diamonds are scarce, the "marginal unit" still available is allocated to highly valued ends. That is why its price is high.

4. Importance in Human Action

Marginal utility is the basis of all Austrian economics because it explains how prices are formed in the market. Exchanges occur because both parties value what they receive more than what they give up at the margin, that is, the additional or one more.

If you buy a coffee for $2, it is because for you the marginal utility of that coffee is greater than the marginal utility of those $2. The seller thinks exactly the opposite. Both improve their subjective situation.

This article is part of the Basic Liberalism Course -> Module 5: Notions of Austrian Economics

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Categories: Home -> Economy Last updated: 2026-05-02

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