Law of Equi Marginal Utility helps to explain consumer behavior in the case of more than one good or service. There is no limit to human wants, but the income to satisfy those wants is limited. So, the law of equi marginal utility explains how a consumer allots their limited income to various goods and services to attain maximum satisfaction.
Australian economist H. H. Gossen was the first to come up with this law. Thus, we also call this law Gossen’s second law, the law of maximum satisfaction, or the law of substitution. We can also call it the principle of proportionality between prices and marginal utility (MU).
We can also call the law of equi marginal utility an extension of the law of diminishing marginal utility. This is because a buyer can achieve maximum satisfaction by spending on different products in such a way that the last dollar spent on each product offers equal MU.
Explanation: Law of Equi Marginal Utility
To get maximum satisfaction, a consumer needs to compare the satisfaction they get from each dollar spent on different goods. Or, the consumer needs to spend the income in a way that the marginal utility of all the things is equal. Suppose the dollar spent on one product gives the buyer more satisfaction than the same dollar spent on another product. In that case, the buyer will continue to spend on the former product until the satisfaction from the last dollar spent on the two products is equal.
Or, the buyer will substitute a few units of a product that gives him more satisfaction for some units of the product that gives him less satisfaction. Now because of consuming more of one product, its MU will drop, while the MU of the other will go up. Such a process will continue until the MU’s of two are equal. This is the law of law of equi marginal utility.
Assumptions of Law of Equi Marginal Utility
Following are the assumptions of the law of equi marginal utility:
- Prices of the products don’t change.
- The income of the consumer doesn’t change.
- MU of the money remains constant.
- The buyer has complete information on the utility they get from the product or services.
- The buyer acts rationally to maximize satisfaction.
- The consumer is able to express or measure utility in cardinal terms.
- Products have substitutes, and the consumer has many wants.
- The Law of diminishing marginal utility forms the basis of this law.
Assume Mr. A has two products of his choice – chocolates, and ice-creams, and has $7.
|Units||MU of Ice-cream||MU of Chocolates|
Suppose Mr. A spends $3 on ice-creams and $4 on chocolates. In this case, the marginal utility of the 3rd ice cream is 6, while of 4th chocolate is 2. Since the MU of ice cream is more than the chocolate, Mr. A will continue to buy more ice-creams and fewer chocolates.
Now, Mr. A buys one more ice cream and one less chocolate, or four ice-creams and three chocolate. Now, the MUs of both are the same at 4. So four ice creams and three chocolates give Mr. A the maximum satisfaction.
We can calculate the total utility (TU) for this combination. TU for 4 ice-creams is 28 (10 + 8 + 6 + 4), while for three chocolates is 18 (8 + 6 + 4). So, TU for the combination is 46. The total utility from no other combination (with $7) will be more than the TU of the above combination (four ice creams and three chocolates).
So, Mr. A was able to maximize satisfaction by equalizing the MUs by substituting the product that gives more utility with the one less useful.
Importance of Law of Equi Marginal Utility
The following points will help to bring out the importance of the law of equi marginal utility:
- It helps a rational consumer to maximize satisfaction using their limited resources. To maximize the satisfaction level, the consumer makes an effort to equalize the weighted marginal utility of all products.
- This law helps producers with production. Producers have limited resources to buy various factors of production. So, the producer makes an effort to equalize the MU of all factors to achieve the maximum output and profit.
- This law also forms the basis of the distribution of income among factors of production. An entrepreneur would pay each factor as per the marginal productivity, which is measurable in monetary terms. Also, the entrepreneur can substitute one factor with another until the marginal productivity of the factors is the same on the basis of the money they get for their services.
- It assists during the exchange of goods and services also. Usually, people exchange a product that has low utility with a product that gives them higher utility. So, in a way, this law helps in the exchange wealth, trade, import, and export.
- Government can use this concept in public finance to attain the maximum social advantage. For this, the MU of every dollar spent on one segment must equal the MU of a dollar spent on all other segments.
- One can use this law to efficiently allocate time between work and rest. To decide between the work and rest hours, one needs to compare the MU work with the MU of rest.
- One can also use this law to decide between saving and spending. For this, the consumer needs to decide between the present and future needs. If the consumer believes that a dollar saved has more utility than the dollar spent, then the consumer will save more. The consumer will continue to save until the MU of the money spent and saved are equal.
- It helps with pricing as well. The prices of product go up if it is scarce. So, this law says that one should go for the substitute, which is less scarce. Such an action would help to push down the price of the primary product.
Exceptions to Law of Equi Marginal Utility
Though the law of equi marginal utility has many applications, it is not without exceptions. Following are situations or scenarios when this law won’t work (we can also call these the limitations of this law):
- This law isn’t applicable in the case of knowledge. For instance, reading more and varieties of books gives more satisfaction to a scholar.
- Also, this law doesn’t apply to indivisible goods. This is because consumers cannot divide the product to adjust the utility.
- In the case of fashion and customs also, this law doesn’t hold. This is because people generally tend to spend money on birthdays, marriages, and deaths.
- This law won’t work if a consumer’s income is very low, as maximizing utility isn’t possible due to low income.
- Calculating MU for durable products isn’t possible. So, this law doesn’t work for durable goods as well.
- If the goods of a consumer’s choice are unavailable, then this law won’t work. It is because the consumer, in this case, will go for the product that gives him some satisfaction than products that hold no utility at all.
- Some consumers don’t care for maximizing utility, or they are lazy consumers. Such buyers will continue to consume products disregarding utility.
- This law won’t work when the products face frequent price changes. Price changes make it harder to calculate the utility of products.
- When there is no limit on resources, there is no need to divert resources from one product to another. So, the law won’t hold. Gifts of nature, such as water, are an excellent example of this.
- Law of Diminishing Marginal Utility
- Consumer Equilibrium – Meaning, Example, and Graph
- Types of Utility – Form, Time, Place, Possession, and Other Utilities
- Indifference Curve – Meaning, Features, Example, and Graph
- Total Utility – Meaning, Importance, and Example
- Why Must Marginal Utility be Equal to Price?