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. Insights

    What is a Complement?

    A good or service that’s used in conjunction with another good or service is a complement.
  3. 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.
  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

    Trade Bond ETFs Using Yield Curves

    Different types of yield curves provide important insights for trading bond-based securities.
  6. 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.
  7. Investing

    Will an Inverted Yield Curve Happen Again?

    Explore the causes of inverted yield curves, their frequency, their accuracy in forecasting recessions and whether this type of event can happen again.
  8. Investing

    Understanding the Inverted Yield Curve

    An inverted yield curve occurs during the rare times when short-term interest rates are higher than long-term interest rates.
  9. Investing

    Walt Disney World Making Some Hotels Dog Friendly

    Up until a few days ago, the only dogs you would see in Walt Disney (NYSE: DIS) World's hotels were Goofy, Pluto, and service animals. That's not so anymore. The entertainment giant has decided ...
Hot Definitions
  1. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  2. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  3. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  4. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
  5. Solvency

    The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...
  6. Dilution

    A reduction in the ownership percentage of a share of stock caused by the issuance of new stock. Dilution can also occur ...
Trading Center