The Marginal Utility of a Dollar

I’m currently in the middle of reading Thomas Piketty’s “Capital in the Twenty-First Century.Hailed as a definitive book on the distribution of wealth of our time, the book is quite a hefty tome, every page loaded with so much information that I find myself re-reading many pages and having to set the book down to absorb something new.

Utility levels out as more and more "investment" is spent.

Utility levels out as more and more “investment” is spent.

I’ve never study economics before, so many of the ideas introduced by Piketty are new to me. Thankfully, he doesn’t assume his readers have a background in economics and takes the time to break down basic concepts. I was particularly interested in “Marginal Utility,” or the measurement of gain or loss on an expenditure. In the context of Piketty’s book, he discusses the Marginal Utility of invested capital (wealth). In his words, if one invests $100 in agricultural land and can produce $5 worth of food from this investment, the marginal utility would be this $5 of product. Pretty simple right? Now here’s where it gets interesting: while we can safely assume that investing another $100 would yield an additional $5. What about an additional $1000? Not so fast. At some point, Marginal Utility will decrease. You can only squeeze so much food out of your available land. Perhaps that last $1000 will only yield an extra $5 of food, greatly decreasing its overall utility. Incidentally, this is what happens to an economy with tons of excess capital floating around. You get more and more investors chasing fewer and fewer yield opportunities, and consequently investment returns go down.

Can we apply Marginal Utility to personal finance? Each of us has a limited number of dollars to spend (unless your Bezos or Buffet, or Gates. In that case, would you like to sponsor my blog? I promise high marginal utility!). Therefore, it would be prudent to spend each dollar with an eye to maximizing its Marginal Utility. For this concept to fit personal consumption, we merely need to change the definition of utility to a more basic understanding of the word, Utility as in “does the job,” or even “happiness.”

Burger utility

Let’s say you’re hungry and there’s a burger selling for $1. The burger costs you 1 dollar, but would easily yield 2 units of happiness (I realize this is arbitrary, but bear with me). You finish your burger and are no longer hungry, but you’re also not stuffed. There’s another burger for sale and, you’re in luck, you have a second dollar! The second burger costs $1, but perhaps now only yields a single unit of happiness. The Marginal Utility has decreased. You’re pretty full. There’s a third burger for sale. You’re appetite knows no bounds and you pony up your third and final dollar. What’s the marginal utility of this third burger? At the very least it hovers near zero (you’re already stuffed, will you enjoy a third burger? Will the calories do you any good?), more likely it has a negative marginal utility.

This basic concept works across all aspects of our budget. Our first dollars have great Marginal Utility, buying us necessary food, shelter, clothing, and transportation that greatly increase our happiness, fulfilling needs. As we spend more dollars, however, the Marginal Utility levels out, taking more and more dollars to acheive less and less happiness/utility.

My partner and I have found this concept very useful when applied to a household budget. Take for example, going out to eat. Our first night out-to-eat yields great Marginal Utility. But adding more nights out reduces that utility. By the third meal out, we may find ourselves actually longing for home cooked meals. The dollars spent on those latter meals have horrible marginal utility. We now space our nights out accordingly.

This concept is incredibly flexible. Take backpacking tents. I was recently looking to purchase a new backpacking tent that would fit 2 people and a dog. Zpacks makes an amazing Cuben fiber tent, the Triplex, that only weighs 23.8 ounces. It also costs $700 dollars and is made from a material that is not known being durable. This is a tent used by people who thru hike long trails like the AT or PCT. On the other end of spectrum is the REI Quarter Dome 3 which weighs 4lbs 3oz and costs $379. In the end, I went for a middle option, the Copper Spur UL 3. The Zpacks is clearly overkill for my weekend backpacking needs and therefore the Marginal Utility of such a purpose would be poor. Why not purchase the REI tent? While its marginal utility would’ve been the highest (dollars spent for satisfactory shelter), I found the extra weight savings of the Copper Spur provided enough extra utility to justify the increased costs. The key is to always weigh the marginal utility of every dollar.

Don’t get lost in the race to purchase every greater things, to spend extravagantly over tiny differences in products. Often the cheapest option isn’t the best, but neither is the most expensive. I, like most, like having the best things, but do I really need a bike designed for Lance Armstrong, boots meant for fighting forest fires, or a Goretex jacket meant for skiing the alps? Do you need all-wheel-drive when you live somewhere where it only snows a half dozen times a year? Perhaps those dollars would be better spent by staying home on snowy days (or waiting till the roads are plowed), and putting those extra dollars into a lifetime supply of hot chocolate.

Marginal Utility is a concept we should all apply to 0ur life. Whenever making a decision or purchase, make sure you weigh the marginal utility of your options.