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 a Complement?

    A good or service that’s used in conjunction with another good or service is a complement.
  2. Investing

    Burger King's New Hot Dogs:Vertical Integration Genius

    Burger King is moving beyond burgers into hot dogs. Here is why this is a smart move.
  3. 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.
  4. Investing

    Don't Dump On The Dogs

    Just because a stock is in a slump doesn't mean it's time to sell. Some value managers make a living by investing in "dogs."
  5. Investing

    Dogs of the Dow for 2017

    With all eyes focused on the Dow's recent rally, there is one investment strategy that couldn't care less.
  6. Investing

    What's a Substitute?

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

    Yield Curve

    Learn more about how this curve is used to predict changes in economic output and growth.
  8. 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.
  9. Investing

    Trade Bond ETFs Using Yield Curves

    Different types of yield curves provide important insights for trading bond-based securities.
Hot Definitions
  1. Ex-Dividend

    A classification of trading shares when a declared dividend belongs to the seller rather than the buyer. A stock will be ...
  2. Debt Security

    Any debt instrument that can be bought or sold between two parties and has basic terms defined, such as notional amount (amount ...
  3. Taxable Income

    Taxable income is described as gross income or adjusted gross income minus any deductions, exemptions or other adjustments ...
  4. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly AIMR) that measures the competence and integrity of financial ...
  5. Initial Coin Offering (ICO)

    An Initial Coin Offering (ICO) is an unregulated means by which funds are raised for a new cryptocurrency venture.
  6. The Bernie Madoff Story

    Bernie Madoff ran a multibillion-dollar Ponzi scheme that is considered the largest financial fraud of all time.
Trading Center