20.2: Diminishing Marginal Utility of Income

Utility reflects the satisfaction individuals gain from consuming goods and services. As income rises, people can afford more goods and services, increasing overall satisfaction. So, utility and income are related. Economists often assume utility can be measured numerically to analyze the relationship between utility and income. They often assume most people experience diminishing marginal utility of income.

Diminishing marginal utility suggests that each additional dollar of income provides less satisfaction than before. The effect is not necessarily linear—the degree of diminishing marginal utility varies by income level and individual preferences. In other words, an initial increase in income significantly enhances well-being. However, subsequent increases lead to smaller gains in satisfaction.

Also, an income loss is perceived to have a stronger impact on well-being than an equivalent income gain. This means a reduction in income leads to a larger drop in utility than the increase in utility generated by the same amount of additional income.

Understanding the diminishing marginal utility of income is essential for analyzing consumer behavior.

Utility measures the satisfaction an individual gets from consuming products. 

Income enables the purchase of these products. So, utility and income are related.

Consider John. As his income increases, he purchases more products, leading to higher utility.

Economists often assume utility can be measured numerically to analyze the relationship between utility and income. Additionally, they assume most people experience diminishing marginal utility of income.

For example, the first $20,000 of John's income provides 20 units of utility, while the next $20,000 adds only 12. Thus, at $40,000, John's total utility increases, but the additional utility from the second $20,000 is less than the first.

This also means that John perceives a loss of income as more significant than an equivalent income gain. For example, if John's income drops from $40,000 to $20,000, he loses 12 utility units. However, an increase from $40,000 to $60,000 gains him only six units of utility.

Understanding the diminishing marginal utility of income helps to analyze consumer behavior.