Marginal Rate of Substitution
Definition of 'Marginal Rate of Substitution'
The amount of a good that a consumer is willing to give up for another good, as long as the new good is equally satisfying. It's used in indifference theory to analyze consumer behavior. The marginal rate of substitution (MRS) is calculated between two goods placed on an indifference curve, displaying a frontier of equal utility for each combination of "good A" and "good B". The marginal rate of substitution is always changing for a given point on the curve, and mathematically represents the slope of the curve at that point. MRS is calculated using the following formula:
Investopedia explains 'Marginal Rate of Substitution'
The Law of Diminishing Marginal Rates of Substitution states that MRS decreases as one moves down the standard convex-shaped curve, which is the indifference curve.
For example, a consumer chooses between hamburgers and hotdogs. In order to determine the marginal rate of substitution, the consumer is asked what combinations of hamburgers and hotdogs provide the same level of satisfaction. When these combinations are graphed, the slope of the resulting line is negative. This means that the consumer faces a diminishing marginal rate of substitution: the more hamburgers they have relative to hotdogs, the fewer hotdogs the consumer is willing to give up for more hamburgers. If the marginal rate of substitution of hamburgers for hot dogs is 2, then the individual would be willing to give up 2 hotdogs in order to obtain 1 extra hamburger.
The marginal rate of substitution does not examine a combination of goods that a consumer would prefer more or less than another combination, but examines which combinations of goods the consumer would prefer just as much. It also does not examine marginal utility – how much better or worse off a consumer would be with one combination of goods rather than another – because all combinations of goods along the indifference curve are valued the same by the consumer.