Understanding the Law of Diminishing Marginal Utility in Finance
Explore how satisfaction decreases as consumption increases and its implications for financial decision-making
What 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.
Key Principles:
- Each additional unit provides less satisfaction than the previous one
- Applies to both consumer goods and financial assets
- Helps explain consumer behavior and investment decisions
- Forms the basis for downward-sloping demand curves
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Financial Applications
Investment Portfolio Management
In portfolio management, diminishing marginal utility explains why diversification is crucial. As investors add more of the same asset type, the marginal benefit of risk reduction decreases.
Consumption Planning
Understanding diminishing returns helps in optimal resource allocation and budgeting decisions.