Marginal Rate of Substitution is a common term for the folks studying economics and for those who deal with economics in their daily lives such as economists, professors teaching this subject, finance people, etc. But, for those who have nothing to do with economics will find this long word complex.
Don’t worry it is not at all complex and we will guide you in this article about what it is and what it signifies. Also, we will let you know about the indifference curve so stay on the track and know about it.
What is the Marginal rate of substitution?
It is the rate at which a consumer is willing to forgo the number of units of a good A for one more similar good B at the same utility. Also, we can say that it is the rate at which consumers are willing to give up commodity ‘A’ for one more unit of commodity ‘B’.
The satisfaction of the consumer will remain the same by consuming either of the products: A or B but the consumption of the quantities will vary.
This term is used to analyze consumer behavior. With this, economists come to know the preference of one product over the other and can get an understanding of the demand for similar items sold in the market.
This is a very useful concept and using it, marketers can get to know the demand of their product against their substitutes in the market and can prepare a good marketing strategy to tackle it.
The marginal rate of substitution is plotted with an indifference curve. This curve shows how much product B will the consumer consume in order to get the same satisfaction he gets with product A. It shows that the consumer is indifferent and gets equal satisfaction with both products though by consuming different quantities of both products.
Let’s understand it by example, for example, a consumer consumes 2 quantities of pizzas and gets satisfied and now it has to be substituted by some other product, let’s say sandwiches. And the consumer consumes 4 quantities of sandwiches to get satisfied. So, the consumer is indifferent and gets equal satisfaction with both pizzas and sandwiches though consuming different quantities.
This below-shown utility function (U) is a function of the quantities of goods and correctly shows the concept of the marginal rate of substitution. Here, x1 and x2 are commodities.
U = f (x1, x2) = constant = U0.
The indifference curve shows that the quality consumed of one product is compensated by the increase in the quantity consumed of the substituted product.
The marginal rate of substitution formula is shown below:
M.R.S. Y X = Δ X / Δ Y, on any point on the indifference curve.
So, it is the slope of the indifference curve at any point. Slopes will change as you move along the curve. If the slope is constant then the curve is a straight line (a downward sloping straight line).
The following are the assumptions made while plotting the indifference curve:
- The consumer is rational.
- Substitutable goods are consumed.
- The availability of more goods is always better.
- There will be transitivity property applied which means that if the consumer prefers product ‘X’ over product ‘Y’. Also, if he prefers product ‘Y’ over product ‘Z’ then it implies that he prefers product ‘X’ over product ‘Z’.
- No time gap between consumption.
- Income, preference, taste, and fashion of the consumer are not changing.
- The utility is cardinal.
Below shown are the properties of the Indifference Curve:
- There is a negative slope of the indifference curve.
- There is no intersection of the Indifference curves.
- They are convex from below, i.e., convex to the origin.
- More utility is yield by the indifference curve that lies to the right side of the other one.
Now, there are three types of Marginal rate of substitution based on the willingness of the consumer to give up one product to consume its substitute.
If the consumer is willing to give up less and fewer units of good X to consume its substitute Y then it will be a Diminishing type.
It will be constant when the consumer gives one unit of good X to consume its substitute good Y.
If the consumer is willing to give more good X to consume its substitute Y to maintain the same level of satisfaction then it will be of Increasing type. In this case, the curve will be concave to the origin.
So, here was an overview of the concept of the marginal rate of substitution. We hope that you got a clear idea of it and now this concept of economic development doesn’t look complex to you and can explain the same to your friends as well.
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