Marginal Rate of Substitution

AAA

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.

 

 

RELATED TERMS
  1. Law Of Demand

    A microeconomic law that states that, all other factors being ...
  2. Substitution Effect

    The idea that as prices rise (or incomes decrease) consumers ...
  3. Marginal Utility

    The additional satisfaction a consumer gains from consuming one ...
  4. Opportunity Cost

    1. The cost of an alternative that must be forgone in order to ...
  5. Consumer Surplus

    An economic measure of consumer satisfaction, which is calculated ...
  6. Marginal Rate Of Transformation

    The rate at which one good must be sacrificed in order to produce ...
Related Articles
  1. Economics

    Economics Basics

    Learn economics principles such as the relationship of supply and demand, elasticity, utility, and more!
  2. Fundamental Analysis

    How Influential Economists Changed Our History

    Find out how these five groundbreaking thinkers laid our financial foundations.
  3. Entrepreneurship

    Cost-Push Inflation Versus Demand-Pull Inflation

    Gain a deeper understanding of aggregate supply and demand, forces which raise the price of goods and services.
  4. Economics

    Introduction To Supply And Demand

    Find out all about supply and demand and how it relates to your daily purchases.
  5. Economics

    Understanding Supply-Side Economics

    Does the amount of goods and services produced set the pace for economic growth? Here are the arguments.
  6. Economics

    Adam Smith: The Father Of Economics

    This free thinker promoted free trade at a time when governments controlled most commercial interests.
  7. Economics

    The Uncertainty Of Economics: Exploring The Dismal Science

    Learning about the study of economics can help you understand why you face contradictions in the market.
  8. Economics

    How Economic Reality Influences The Market

    The market is confusing enough. But when you consider how economic reality can influence market prices, it's downright baffling.
  9. Economics

    A Practical Look At Microeconomics

    Learn how individual decision-making turns the gears of our economy.
  10. Personal Finance

    Microeconomics

    This tutorial teaches the basics of one of the most important economic topics. A must for all investors.

You May Also Like

Hot Definitions
  1. Interest Rate Risk

    The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between ...
  2. Income Effect

    In the context of economic theory, the income effect is the change in an individual's or economy's income and how that change ...
  3. Price-To-Sales Ratio - PSR

    A valuation ratio that compares a company’s stock price to its revenues. The price-to-sales ratio is an indicator of the ...
  4. Hurdle Rate

    The minimum rate of return on a project or investment required by a manager or investor. In order to compensate for risk, ...
  5. Market Value

    The price an asset would fetch in the marketplace. Market value is also commonly used to refer to the market capitalization ...
  6. Preference Shares

    Company stock with dividends that are paid to shareholders before common stock dividends are paid out. In the event of a ...
Trading Center