The marginal utility analysis has a good number of uses and applications in both economic theory and policy. Following are the applications and uses of diminishing marginal utility:
(i) The law of diminishing marginal utility is of crucial significance in explaining determination of the prices of commodities. The discovery of the concept of marginal utility has helped to explain the contradiction of money which troubled Adam Smith in ‘The Wealth of Nations’. Adam Smith was greatly perplexed to know why water which is so very essential and useful to life has such a low price (indeed no price), while diamonds which are quite unnecessary, have such a high price. This value paradox is also known as Water-Diamond Paradox. But modern economists can solve it with the help of marginal utility concept. According to the modern economists, the total utility of a commodity does not determine the price of a commodity and it is the marginal utility which is crucially, an important determinant of price. Now, the water is available in abundant quantities so that its relative marginal utility is very low or even zero. Therefore, its price is low or zero.
(ii) Another important use of marginal utility is in the field of fiscal policy. In the modern welfare state, the Government redistributes income so as to increase the welfare of the people. This redistribution of income through imposing progressive income taxes on the rich sections of the society and spending the tax proceeds on social services for the poor people is based upon the diminishing marginal utility. The concept of diminishing marginal utility demonstrates that transfer of income from the rich to the poor will increase economic welfare of the community.
