Marginal Utility of Income

[padasala]

Hi,

I was hoping to get a query answered.

The CMP does not seem to shed a lot of light on the marginal utility of income...my mom(an economist herself) mentioned to me that "money is generally an exemption to utility theory"....

Thus, I got a little confused when I came across marginal utility of income (because it does not make sense, to me at least, when I say that my marginal utility will decrease for every additional dollar that i earn)...Human behavior will ensure that utility is maximized for every additional dollar earned (in which case, it does not seem likely that the marginal utility theory for income should hold)...

I then read online about how marginal utility of income is a measure of risk apetite...which got me thinking... does marginal utility measure the probability of a person accepting a gamble for additional income (at the cost of his current income)?

For instance, does MU for Income measure the additional utility that a person derives when accepting a wager for $100 (assuming he loses $100 and gains $200 in the event of a win or a loss)...

In this case, the MU for a risk averse person would be less thn the MU for a risk loving person (or a risk neutral person for that matter)..

Please do let me know if my train of thought and logic is sound in this


Thanks!

Regards,
Sunil

 

[Margaret Wood]

The marginal utility is the additional satisfaction gained from an extra unit of a commodity or income. Most people agree that as you consume more of a commodity, such as a chocolate bar, the extra satisfaction that an extra unit gives you falls, ie the marginal utility falls. As long as the MU is positive however, the total utility will increase as consumption increases.

What about income or wealth? I think most people will still agree that MU falls with increases in income, eg if you have an increase in income of £1,000 you say "wow - that's amazing"; if you then have another increase of £1,000, you say "that's nice"! Maybe! Everyone's different!

Suppose you have wealth of 100 and someone offers you a fair gamble - you have a 50-50 chance of gaining 10 or losing 10. Would you accept?

(1) If you reject, you are risk-averse - your MU decreases with income, so the additional utility of winning the 10 is less than the loss of utility of losing the 10
(2) If you are indifferent, you are risk-neutral - your MU is constant with income so the additional utility of winning the 10 is the same as the loss of utility of losing the 10
(3) If you accept, you are risk-seeking - your MU increases with income so the additional utility of winning the 10 is greater than the loss of utility of losing the 10.

Hope this helps.

 

[padasala]

Completely agree with you on the gamble ...one thing which i contest with is:

"What about income or wealth? I think most people will still agree that MU falls with increases in income, eg if you have an increase in income of £1,000 you say "wow - that's amazing"; if you then have another increase of £1,000, you say "that's nice"! Maybe! Everyone's different!"

I only contest it because of the popular paradigm "wants are unlimited and means are limited"... so if we adhere to that, and if we are treating money as a commodity, wont MU systemically increase?

For instance, if we get an increase of $1000, we immediately think of what where we are going to spend it (even if we think of saving it, it increases our utility right?)...

now if we get another $1000 increase in salary, aren't we, as humans planning on spending that as well? dont we, as humans "learn how to spend whats in our pockets" (sorry...im quoting Paul Bettany from Margin call here )

My question here is should we treat money (as a commodity) as an exception to MU?

Should MU in terms of income be only a measure of the risk apetite of a person?

 

[Margaret Wood]

Even if marginal utility is falling, as long as it's positive, then total utility will increase. All we are saying is that the rate of increase in total utility slows down. In the case of income, we usually assume non-satiation, ie positive MU, so we always get some extra satisfaction from an extra unit of income, (unlike perhaps an extra chocolate bar, which might make us feel sick!). This means that total utility never falls with an increase in income.

 

[cjno1]

We have marginal utility because our wants/needs are ordered, in other words we want some things more than others and it depends on your situation what that ordering is.

If you have no money at all and you are homeless, your most prominent need might be food. So if someone gives you £10, you derive a huge amount of utility from that because it means you can meet your most important need. If someone gives you another £10 then you can meet the next important need (e.g. buying a blanket for heat).

So yes, you will still plan to spend more money if you are given it, but you will naturally plan to spend it on less and less important things each time, things which derive less utility. So your marginal utility from income still decreases.

£1000 given to a homeless person will give them far more utility than £1000 given to a millionaire.