As an economics graduate, I found that what I studied in university had very little to do with reality. However, it was still very interesting and a small part of it is very applicable to our life. One of the most applicable and interesting concepts is diminishing marginal utility.
What does diminishing marginal utility mean?
Based on Investopedia, diminishing marginal utility means that “all else equal as consumption increases the marginal utility derived from each additional unit declines”. In simple words, it means that the more you have of something, the less you enjoy/value an additional portion. Another way to look at it is that the less you have of something, the more you enjoy/value.
As I said, this is a very applicable concept in our lives.
Examples of diminishing marginal utility
Water in the desert
You’ve just come out of the desert after you got lost and haven’t had anything to drink for a whole day. You see someone selling water for £1,000 a glass and there’s no other water available around. How many glasses will you buy?
I would probably pay for the first glass as it will be life saving and definitely worth £1,000 for me, maybe even a second and third glass. Will you buy the tenth glass? why not? it is still the same glass of water and the same price.
The reason is that you value the first glass much more than you value the tenth glass, that’s diminishing marginal utillity.
Other economic principles that can be seen here are supply and demand (supply is limited, hence prices are high) and a monopoly (the seller has no competition, hence prices are high).
Let’s do a few more examples.
Same money for different people
Assume you win a competition and the prize is £100,000. How would your life change? How would you rate your joy from 1-10?
Now, imagine Bill Gates wins £100,000. Do you think he will answer these questions the same as you did? Probably not. He probably has more money than you (Elon, based on this list this doesn’t apply to you, please let me know you’re reading this in the comments section). Because he has more of something (in this case, money), he probably enjoys the additional money less than you. Woohoo! you can enjoy life more than Bill Gates! talk about a silver lining.
The prize draw
Understanding the concept of diminishing marginal utility can also explain people’s decisions.
Let’s say you can choose between a 50% chance (coin flip) of getting 10x or a guaranteed 1x, what would you choose?
From a purely mathematical/statistical perspective, you should choose the coin flip as 50% * 10x = 5x which is more than 1x. However, I want to show you that the value of x makes all the difference. We’ll start with x=£1 and multiply by 1,000 each time we move to the next scenario.
Scenario 1: x= £1
What would you choose: a guaranteed £1 or a 50% chance at £10?
You can answer for yourself but as both amounts won’t affect my life at all, I would probably choose the coin flip just for the excitement of the game/gamble.
Scenario 2: x= £1,000
What would you choose: a guaranteed £1,000 or a 50% chance at £10,000?
This is a bit harder because I could use £1,000 and could definitely use £10,000. I think here I would choose the coin flip because of the math. 50% * £10,000 = £5,000 which is more than £1,000. However, in the next example, I completely ditch that logic.
Scenario 3: x= £1,000,000
What would you choose: a guaranteed £1,000,000 or a 50% chance at £10,000,000?
As an additional £1,000,000 will allow me to reach FI and live me dream life, I would probably choose the guaranteed £1,000,000. Why did I change my logic? because once I have £1,000,000 an additional £9,000,000 (from £1m to £10m) means very little to me, it is the state of “enough”.
However, I know that some of you would choose the coin flip as £10,000,000 would probably allow you to live like a movie star- buy a big house, nice car, travel the world and enjoy (almost) everything this world has to offer.
Scenario 4: x= £1,000,000,000
What would you choose: a guaranteed £1,000,000,000 or a 50% chance at £10,000,000,000?
I think all of you would agree with me here- we would all take the guaranteed £1,000,000,0000. This is so much money that even multiplying it by 10 won’t make any difference (unless you have an urge to buy a sports team or something like that). This scenario shows a situation where you have so much of something that the marginal utility of additional units is almost 0. I am almost certain that my life would be exactly the same if I had £1bn or £10bn.
What has diminishing marginal utility got to do with FI?
As we saw in the above examples, the more we have of something, the less we enjoy/value the next unit. It doesn’t mean we don’t value the next unit, we just value it less than the previous unit.
This basically means that the less we have of something, the more we value each unit.
Let’s apply this to money and free time and you’ll see why this concept is relevant for FI.
Extra hours for the same hourly wage
Your boss comes to you and asks you to work 50% more hours a day from now on for 50% more pay (same hourly wage), would you accept?
If you can’t make ends meet, you will probably accept as the utility of the extra money is very high for you. You might also accept for the short-term.
Most of us would refuse and I’ll explain why:
- The extra money will give me less joy/value than the previous money. Therefore, I will get less joy/value for every extra hour I work as it’s the same hourly wage.
- As I work more, I will have less free time. As I have less free time, I value every free hour more. That means that in order for me to give up an extra free hour, I would need to be compensated MORE per hour.
Diminishing marginal utility actually has a double effect on our choice of how many hours to work. It also explains why we call it “work-life BALANCE”. The ideal point is where an extra hour of free time is worth (to us) exactly our hourly wage, that’s when we don’t want to give up the additional money for more free time but also don’t want to give up the free time to work and earn more, the perfect BALANCE (until you reach FI).
As we saw, the more we have of something, the less we enjoy/value the next unit. Of course, this only applies to “normal” things (things that we enjoy/value). This does not apply to diseases etc.
We also saw that the less we have of something, the more we enjoy/value the next unit.
In simple terms, I think diminishing marginal utility describes “enough”, which is a powerful concept. Once we have enough, we don’t really need more of it.
For me, once I reach my FI number (the net value which will allow me to be financially independent), I will probably leave my job and spend a lot more time with my family as I described in a separate post. However, once I have all that free time, maybe I’ll value each free hour less and want to work part time, who knows?
Let me know in the comments section what you would choose for each prize draw and why.