Friday, 16 January 2015

Law of Diminishing Marginal Utility as a Guide to Price fixation

In economics it is generally observed that if you go on consuming more of anything, the satisfaction or utility that you derive from extra unit is gradually decreased. If you go on consuming in spite of this diminishing utility,one point may arise where your satisfaction from one more extra unit is zero and then it will go in minus figures. So, ultimately, your total utility also gets decreasing by each extra unit of consumption. It can be harmful or even dangerous to you if you continue consuming those products.

For example, take a plate of meals. From the first plate of meals, suppose you get utmost satisfaction say 100 points. If you go for another round, you may get 60 points and from a third round you may get only 30 points. If you take one more round, then, it may not give you any more utility and it will become 0 points or in negative points from that round. You may even begin to vomit and get sick.

So, automatically, you will stop consuming more of that product even at a second or third round itself.

Hotels and Restaurants assume this law of diminishing utility as their safe point when they run full meal menus or buffer systems. Because, they are confident that nobody can eat excessively more than upto a certain limit. So, they can safely fix the prices of food according to that maximum limit calculated through this law of diminishing utility as follows:

In the above example of meals, the marginal utilities at each stage are as follows:
1st plate 100 points, 2nd round 60 points, 3rd 30 points and 4th 0 points. So, total utility you get from four rounds is (100+60+30+0) = 190 points.

Now, suppose each person has different capacities of eating. One person consumes only one round. The second takes two rounds and like that. So if there are 4 people, total rounds taken by them can amount to say 10. Now, you will have to calculate the price of food by calculating the average consumption per head which comes to 10/4 =2.5 times. The price per one person can be fixed at 2.5 times of the cost of one meal plate which can be a safer price from the point of view of the management of the restaurant. In this way the law of diminishing utility can be a very useful determining factor for fixing prices.

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