Law of Diminishing Marginal Utility: How Do They Fix Prices?

In economics, it is generally observed that if you go on consuming more of anything, the satisfaction or utility that you derive from an extra unit gradually decreases. If you go on consuming in spite of this diminishing utility, a point may arise where your satisfaction from one more extra unit is zero, and thereafter it will go into negative figures. 

Ultimately, your total utility decreases with each extra unit of consumption. It can be harmful or even dangerous to you if you continue consuming those products.

Example for Diminishing Marginal Utility

For example, take a plate of meals. From the first plate of meals, suppose you get the utmost satisfaction, say 100 percentage. If you go for another plate, you may get 60% satisfaction, and from a third plate you may get only 30%. If you take one more round, then it may not give you any more utility, and it may provide a negative result from that meal. 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.

How do Producers Fix/Determine the Prices of Products

Hotels and Restaurants assume this law of diminishing utility as their safe point when they run full meal menus or buffet systems. (You must be aware that full meals or buffets do not have any restrictions on how much food you eat). As they are confident that nobody can eat (excessively) more than up to a certain limit, they can be free of any losses in their business. 

They can safely fix their prices at an assumed average that falls between the minimum and maximum capacities of customers' intake of food. The rate gets determined through this law of diminishing marginal utility.

Calculation of Full-Meals Price

Suppose a person consumes an entire four-plate meal.

In the above example of meals, the marginal utilities for each extra plate are as follows:
1st plate 100 points, 

2nd plate 60 points, 

3rd plate 30 points, 

4th plate 0 points. 

So, the total utility derived from four plates is (100+60+30+0) = 190 points.

Now, suppose each person has different capacities for eating. One person eats only one plate. The second takes two plates of meals.  The third one consumed three plates. The 4th and 5th customers had two plates of meals each.

The above assumptions are only for calculation purposes. Don't think that a person eats two plates or three plates of meals in a single sitting. Even during buffet dinners, it can't be imagined (where we see people eating lavishly). Think of the plate as another serving of food.

There are 5 people in the example above; the total number of plates consumed is 10. Now, you will have to calculate the price of food by determining the average, which comes to 10/5 = 2 times. The price per person can be set at 2 times the cost of one meal plate, which can be a safer price from the point of view of the restaurant's management. 

So, if the average cost of food cooked per plate was Rs 30, the restaurant can fix the price per meal as twice Rs 30, which amounts to Rs 60.

In this way, the law of diminishing utility can be a very useful determining factor for fixing prices.