Last week I spoke with several florists about pricing and one question kept coming up.
What is diminishing marginal utility again?
We've talked about the concept before but the term is abstract, confusing and easily forgettable.
I think the problem is the word "utility" because it is so vague. If the term was "diminishing marginal benefit" or "diminishing marginal enjoyment" the concept would probably be easier to remember. And in so many cases pleasure, or enjoyment, is the benefit.
In the context of pleasure or enjoyment the diminishing marginal bit is easy to understand. The more you consume of something pleasurable the less enjoyment you will derive from it.
Think about cutting the grass on a hot summer day. The first sip of an ice cold beer afterwards is as good as it gets. The next few are pretty good too, not as good as the first but pretty good. After that it starts to taper off pretty quickly.
Another great example is movie theater popcorn. For a lot of people it is part of the experience, the ritual of going to the movies, and it's reinforced as soon as you smell it. The anticipation continues to build as you wait in line and take it back to your seat. Finally you get to indulge and first few mouthfuls are awesome.
But if you bought the big bag you probably won't finish it. No matter how great it is at first it doesn't last, and most of us put the bag down (with no small amount of self loathing) before we get through the whole thing. That is diminishing marginal utility:
The law of diminishing marginal utility states that 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.
Replace "utility" with enjoyment and it makes perfect sense.
Diminishing marginal utility does not apply to everything. Gasoline is one great example. The utility of gasoline is, for most people, its ability to propel their vehicles a certain distance. That utility does not diminish – the first unit of fuel gets you as far as the last. That is one of the reasons you don't see volume discounts on fuel – there is no need to offset the effects of diminishing marginal utility.
Inside the station it is a completely different story when we get to the soda fountain. Here the law of diminishing marginal utility definitely does apply – the last third of that giant soda, consumed later when it's flat, warm and watered down from the melted ice, does not provide nearly the same utility (pleasure) as the first few sips.
So how does the gas station convince you to buy it? They offset the diminishing marginal utility of that product with a volume discount – the giant soda costs only a little bit more than the next smaller size. It's like they're negotiating with you... "we know you aren't even going to enjoy the last third of this so we'll sell it to you for almost nothing".
Now it's easy to say that the soda has the margins to do that and it's true – the margins on soda are good and give the station more room to discount. But that is the "how" not the "why". They'd be happy to keep the higher margins by pricing consistently on a per-unit basis but they'd lose sales – nobody gets excited about "twice as much soda for twice as much money!".
There is an excellent definition of diminishing marginal utility at the Beyond Cost Plus website, and also some real world examples anyone can relate to. In addition there are many examples of terms and concepts used in pricing.