Friday, July 9, 2010

Law of Diminishing Marginal Utility, Puppy Edition

I have an adorable and playful Wheaten terrier puppy that is just about 12 weeks old now. She is a spoiled little girl as my wife and I have purchased about 18 toys for her over the last few weeks.

When she gets her teeth into the newest toy, she carries it everywhere; brings it to get a drink of water, eat dinner, downstairs to watch TV, and into her crate during bed time. However for each new favorite toy, this only lasts for a few days.

In economics we say that the value of a good, or a squeaky puppy toy, lies at the margin. The first day of seeing her latest stuffed bear, her satisfaction or utility is very high. On day two, she is still happy and her total satisfaction rises, but the additional (marginal) satisfaction is not as great as day one. Day three, four, and five also see an increase in total satisfaction but for each day the additional satisfaction continues to decline.

Another way to look at this situation is to consider that my puppy's current favorite toy is really her 18th favorite toy. It is her flavor of the week, however, the additional satisfaction from the 18th puppy toy is less than the additional satisfaction she experienced from the 17th puppy toy. The 16th puppy toy yielded higher additional satisfaction than the 17th, and so on.

The decline of additional satisfaction is known in basic economics as diminishing marginal utility. It applies to absolutely everything, from the downward sloping market demand curve to consuming a bucket of french fries at your favorite fast food joint. Under this law, we are only willing to buy more of a good at lower prices.

The most famous application is the diamonds-water paradox. The amount of water consumed throughout one's life results in greater total satisfaction than the diamonds one consumes. Then why in the world are diamonds so expensive while water is so dirt cheap?

Well, for one, diamonds are scarce, but most importantly, the additional satisfaction of the last diamond consumed is far greater than the last bottle of water you drank. Where can you find the value? Always at the margin.

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