What Is the Marginal Rate of Substitution?
The branch of economics known as microeconomics concerns itself in part with the actions of consumers. A central concept is the notion that consumers seek to acquire the combination of goods that will yield them the greatest level of satisfaction, which economists call utility. Consumers differ in the level of importance they attach to particular goods and may be willing to exchange one good for an additional unit of another. Economists developed a measure of this, called the marginal rate of substitution.
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Identification
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The marginal rate of substitution is the number of units of product "A" that a consumer must give up in exchange for an additional unit of product "B" to maintain the same level of satisfaction, or utility. The important part of this definition is that even after substituting one unit of "B" for even multiple units of "A," the individual in question is no better or worse off. Under this example, a consumer's preference for product "B" may be such that he or she is willing to give up more than one unit of product "A" to get an additional unit of "B."
Function
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The marginal rate of substitution recognizes that consumers' resources are limited and cannot acquire unlimited quantities of the goods they want. This measure of the relative importance that consumers attach to particular goods is one of many measures that economists use when studying consumer preferences. Consumer preferences and purchasing habits are a large determinant of the overall demand for goods and services in the economy.
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Technical Substitution
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The marginal rate of substitution does not, however, apply solely to the study of consumer behavior. Economists also apply the concept to firms' production of goods, using the term "marginal rate of technical substitution." This term refers to the rate at which firms must substitute one resource used in the production process (also referred to as inputs; labor and materials are examples of inputs) for another to maintain a constant rate of production, or output. For example, economists might calculate the number of workers who could be replaced by one machine at a given factory without changing the factory's output.
Considerations
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Whether applied to consumer demand or production processes, the marginal rate of substitution is not constant. It will differ not only across individual consumers and firms, but also differ by the quantities of goods or resources already being consumed. As an example, suppose an individual's preferences consist of paperback books and CDs. The rate at which this consumer is willing to substitute paperbacks for one additional CD will depend on how many books and CDs he or she already has and whether the person desires more reading material or music.
Budget Constraints and Relative Prices
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Consumer preferences for combinations of goods (such as our hypothetical person's preference for books and CDs) is subject to each individual's budget constraint, or the measure of what a person can afford. A key principle in economics is that consumers will choose the combination of goods subject to the budget constraint so that the marginal rate of substitution is equal to the relative price, or the price of one good relative to the price of another. If, for example, the price of two paperbacks equals the price of one CD, a consumer's marginal rate of substitution is two books for an additional CD.
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