Next video:
Loading the player...

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, you’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 Y-axis and the hamburgers on the X-axis.

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, you’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.

Related Articles
  1. Insights

    What is an Indifference Curve?

    An indifference curve determines the combinations of two goods that will provide equal satisfaction.
  2. Investing

    Barking Up The Dogs Of The Dow Tree

    One well-known and successful strategy for cashing in on dividends is the Dogs of the Dow. Here's what you need to know about them.
  3. Investing

    What's a Substitute?

    A substitute is a good that satisfies the same needs as another.
  4. Investing

    What's a Dog and Pony Show?

    A dog and pony show is a presentation that markets new securities as an initial public offering, or securities on a secondary basis.
  5. Investing

    What Is Supply?

    Supply is the amount of goods a producer is willing to produce at a given price, and is one of the most basic concepts in economics.
  6. Investing

    Understanding Term Structure of Interest Rates

    The term structure of interest rates is a common method of valuing bonds.
  7. Insights

    Understanding the Substitution Effect

    The substitution effect is an economic term used to describe consumer behavior relative to price or income changes.
  8. Small Business

    One-Person Businesses You Can Start Quickly

    Here is a list of professions you can quickly enter with an average-sized to large investment.
Hot Definitions
  1. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
  2. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ability to pay short-term and long-term obligations, also known ...
  3. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
  4. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
  5. Risk Averse

    A description of an investor who, when faced with two investments with a similar expected return (but different risks), will ...
  6. Indirect Tax

    A tax that increases the price of a good so that consumers are actually paying the tax by paying more for the products. An ...
Trading Center