The Marginal Cost Method

The Marginal Cost Method

Marginal utility (MU) is a concept from economics that attempts to quantify the incremental benefit that additional consumption of a good or service provides. The Modified Utility (MU) is calculated by dividing the change in total utility by the change in commodity consumption.MU can be thought of as the increase in utility that results from consuming one more unit of product.

Through Application of the Marginal Utility Theory

The economic principle of usefulness must be grasped. A consumer's utility is the "value" or "pleasure" they derive from a predetermined level of consumption. One definition of utility is the monetary value that consumers are willing to put on the satisfaction that a product or service offers them.

Let's imagine you're shopping for fish because you're hungry and need something quick to put on the table. Let's assume the price of a single fish is $2. The value of the fish is supposed to be $8, if you're so hungry that you'd pay that much for it. So, no matter how much the fish actually costs, $8 is all you need to satisfy your cravings.

Determine the total benefit of obtaining a set quantity of products. When applied to several goods, the concept of utility becomes "total utility." The utility you derive from consuming more than one of a given good can increase, decrease, or stay the same relative to the utility you derive from consuming just one.

To illustrate, suppose you've decided to have two fish for dinner. When you eat the first fish, though, you won't be quite as hungry as you were before. For the added pleasure of a second fish, you'd now only have to pay an additional $6. If you're already feeling full, it won't satisfy you as much. This indicates the "total utility" provided by the two fish is $14, or $6 more than what was provided by the first fish ($8).

It is important to remember that it is irrelevant whether or not you end up purchasing the second fish. MU cares solely about how much you'd be willing to pay for it. Economists in the actual world utilize intricate mathematical models to speculate on what customers would be willing to pay in the hypothetical.

Calculate the overall value of the things you consume. Two total utility measures are required to determine MU. Your MU will be based on the disparity between the two.

In the scenario described in Step 2, you decide you're really hungry and end up eating four whole fish. You might feel a little full after the second fish, so you might only spend $3 for the third fish. When you're practically full after the third fish, you'll only spend a dollar for the fourth.

Almost all of the pleasure it would bring is cancelled out by an unpleasant fullness that lasts for hours. In terms of value, you can calculate that the four fish are worth a total of $18 ($8 + $6 + $3 + $1).

Do the MU. Subtract one set of units from another and multiply the result by the total utility difference. Your final number will represent the marginal utility, or the incremental benefit, of consuming an extra item. Your MU would be determined as follows in the scenario presented:

$18 minus $14 (example from Step 2) = $44 minus $2 worth of fish = $2.

$4/2 = $2

This means that between the second and fourth fish, the incremental value of each additional fish drops to $2. In reality, the third fish is worth $3 and the fourth is worth $1, but this is only the average price.

How to Figure Out Extra Units of Measurement

Calculate the MU of a further unit using the formula provided. The accompanying illustration shows how the MU of commonly consumed items can be calculated. This is an acceptable application of MU. On the other hand, it is more commonly used to refer to consumable items on a per-item basis. This allows us to calculate the exact MU for each supplementary product (not an average value).

You can actually find this rather easily. When the shift in consumer demand is 1, the MU can be calculated with the standard equation.

Each unit's MUs are known to you in this example. In the absence of any prior fish consumption, the marginal utility (MU) of the first fish is $8 ($8 total utility minus the $0 you had before/change of 1 unit), the MU of the second fish is $6 ($14 total utility minus the $8 you had before/change of 1 unit), and so on.

In order to get the most out of the equation, use it to optimize your efficiency. Spending decisions are grounded in economic theory's emphasis on customers' pursuit of utility maximization. That is, they want to get the most value out of their purchases. Customers will continue to buy products until the additional benefit they derive from doing so is less than the additional expense (the price of one more unit).

Find the value of the utility we lost. Let's take a look at the hypothetical circumstance again. At first, we estimated $2 per fish. We then calculated that the MU for the first fish is $8, for the second, it's $6, for the third, it's $3, and for the fourth, it's $1.

With this knowledge, you would not go through with the purchase of the fourth fish. It has a lower marginal benefit ($1) than it does a lower marginal cost ($2).You're missing out on anything of value in this exchange, so it's not a good one.

Drawing on a Marginal Utility Diagram

Quantity, Total Utility, and Marginal Utility could be columns. In MU charts, these three categories are standard.There may be more, but these show the main important details. In most cases, the order is from left to right.

Keep in mind that the column titles may not always correspond to this. The "Quantity" column might be renamed "items bought," "units purchased," or any other appropriate term. The data in the column is what really matters.

If results seem to be getting smaller and smaller, that's a tendency to keep an eye out for. In order to show that a consumer's desire to buy more of a good decreases as they increase their consumption of that good, the "classic" MU chart is frequently employed. That is to say, after a certain threshold is reached, the additional value provided by a certain purchase begins to diminish. 

The customer's level of satisfaction will begin to decline after some time has passed and they have purchased further items.

This law of diminishing returns may be seen taking effect nearly immediately in the above example chart. Each additional ticket to the film festival has less marginal utility than the first. After the sixth ticket, the marginal utility (MU) of the seventh ticket is negative, resulting in lower overall satisfaction. One possible explanation is that after six visits, the customer becomes tired of seeing the same films.

Find the best use of your time. 

At this moment, the marginal price is higher than the marginal utility. How much of a given good a buyer will buy can be easily estimated using a marginal utility chart. Remember that consumers will continue to buy products until the marginal cost of doing so exceeds their marginal utility. At the end of the row, where MU is greater than marginal cost, utility is at its highest. This is true whether or not you know the exact price of the commodities being studied.

In this hypothetical chart, let's imagine that each ticket costs $3. Buying four tickets is optimal in this situation since it maximizes utility. The marginal benefit of the subsequent ticket, at $2, is lower than the marginal cost of $3.

Take into account that when the MU becomes negative, utility may not be at its highest. A product need not be "worth it" to provide some value; the fifth ticket in the above chart still provides $2 worth of MU. Even though this doesn't have a negative MU, it's still not worth it and reduces the overall utility.

Consider the information shown in the charts as a starting point for further research. Once the three "core" columns in the upper part of the chart are obtained, more numerical information regarding the hypothetical circumstance being modeled can be obtained with relative ease. In particular, this is true if you're employing a spreadsheet application like Microsoft Excel, which can perform the calculations for you. You may want to add two more columns to the right of the three already there for the following information:

Standard Utility: The sum of all utilities across a given row divided by the number of commodities acquired.

The consumer surplus is the value of a product's marginal utility subtracted from its marginal cost in each column. It's a measure of the "gain" an individual makes by purchasing a good or service. In economic terms, this is a "surplus."