The marginal rate of substitution is used to determine how much of one good a consumer will give up to obtain extra units of another good while remaining equally satisfied.
To see how the marginal rate of substitution works, plot it on a graph using an indifference curve. An indifference curve is a curved like the outer side of a sphere. It reveals all the combinations of two goods you can own that will provide equal levels of satisfaction.
For example, youâ€™re planning a big summer barbecue and you have 20 pounds of hot dogs and 10 pounds of hamburgers. You plot the hot dogs on the Yaxis and the hamburgers on the Xaxis.
How many pounds of hot dogs would you be willing to give up to obtain three extra pounds of hamburgers, and remain equally satisfied?
If you change the hamburgers to 13 pounds, the number of hot dogs along the indifference curve will fall to 15. That combination of 15 pounds of hot dogs and 13 pounds of hamburgers would provide you the same satisfaction as owning 20 pounds of hot dogs and 10 pounds of hamburgers.
Mathematically, the formula looks like this:
At this point on the indifference curve, youâ€™re willing to give up 1.6 pounds of hot dogs to obtain an extra pound of hamburgers.
As other points are plotted along the indifference curve, the marginal rate of substitution changes correspondingly.
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