Marginal Utility

Marginal utility is the extra satisfaction, benefit, or “happiness” a person gets from consuming one more unit of a good or service. Think of it as the “one-more-slice” effect. That first slice of pizza after a long day? Pure bliss. The second is still great. The third? Pretty good. But by the time you're considering the eighth slice, the thought of it might not be so appealing. The enjoyment you get from each additional slice decreases. This core concept, known as the law of diminishing marginal utility, is a cornerstone of economics that has surprisingly powerful implications for investors. It's not just about pizza; it’s about understanding value, growth, and risk in your portfolio. For a value investing practitioner, grasping this idea helps explain why the relentless pursuit of “more” isn't always the smartest strategy, whether you're buying stocks or slices.

The principle of marginal utility is intuitive and applies to almost everything we consume or acquire. It’s a simple but profound observation about human nature and decision-making.

This “law” states that as a person increases consumption of a product, there is a point at which the marginal utility they gain from consuming each additional unit starts to decline. The total utility (your overall satisfaction) might still be increasing, but the rate at which it grows slows down with each new unit. Let's stick with our pizza example:

• Slice 1: Happiness Boost: +10 utils (units of satisfaction). You're starving!
• Slice 2: Happiness Boost: +8 utils. Delicious and satisfying.
• Slice 3: Happiness Boost: +5 utils. You're starting to get full.
• Slice 4: Happiness Boost: +2 utils. You're pushing it now.

Your total satisfaction after four slices is 25 utils (10 + 8 + 5 + 2), which is high. However, the marginal utility of that fourth slice was only 2 utils, a fraction of the first. This declining value of the “next one” is what matters.

Absolutely. If you force down that eighth slice of pizza, you might feel sick. At this point, the marginal utility has become negative—consuming one more unit has actually made you worse off. Your total satisfaction plummets. This is an extreme but useful way to think about excess in any context, including investing. Adding one more high-risk, speculative stock to an already concentrated portfolio could be the “one slice too many” that brings negative utility by dramatically increasing your risk of ruin.

Understanding marginal utility moves from an academic concept to a practical mental model for making smarter investment decisions.

This is the most direct application in finance. The goal of diversification is to reduce risk without sacrificing too much potential return.

• Adding Your 2nd Stock: The first stock you buy is your riskiest holding. Adding a second, unrelated stock provides enormous marginal utility by significantly reducing your unsystematic risk.
• Adding Your 20th Stock: By the time you're adding the 20th stock to your portfolio, the risk-reduction benefit (the marginal utility) of that addition is much smaller than the benefit you got from the second. You're still diversifying, but the effect is diminishing.
• Adding Your 100th Stock: The marginal utility here is tiny. At this point, you might be heading towards becoming an index fund, potentially overdiversifying and diluting the impact of your best ideas.

The law of diminishing marginal utility tells you that after a certain point (for most experts, around 20-30 well-chosen stocks), the benefit of adding one more stock is minimal.

Investors can use this concept to think about a company's growth. The marginal utility of an extra $1 billion in revenue is vastly different for different companies.

• For a small-cap startup with $50 million in annual sales, an extra $1 billion is transformational.
• For a mega-cap giant like Apple or Amazon, an extra $1 billion is a rounding error, barely moving the needle on their massive revenue base.

This is why finding the “next big thing” is so lucrative. The marginal utility of growth is much higher for smaller, nimble companies. A value investor uses this insight to hunt for opportunities where the market undervalues this future growth potential.

Great investors are students of business, and great businesses understand their customers. A company's success often hinges on the marginal utility of its products.

• Subscription Services: Why does Netflix offer different tiers? Because the marginal utility of “unlimited streaming” is huge for a movie buff but lower for a casual viewer. Tiered pricing captures customers at different utility levels.
• Luxury Goods: The marginal utility of a second Prada handbag is lower than the first. This is why luxury brands must manage scarcity and brand value so carefully to maintain high pricing power.

By analyzing a business through this lens, you can better assess its long-term competitive advantage and profitability.

Marginal utility is a simple concept with a fancy name. It reminds us that context is everything. The value of one more dollar, one more stock, or one more slice of pizza depends entirely on what you already have. For investors, it serves as a powerful mental tool to promote rational decision-making in portfolio construction, company analysis, and risk management. It’s the voice in your head that wisely asks, “Is more really better right now?”