The marginal rate of substitution is a concept in microeconomics that measures the rate at which a consumer is willing to consume an extra good of one type in exchange for consuming a good of another type. It expands on concepts such as utility and the law of diminishing utility, and it may derive from indifference curves.
In microeconomics, "utility" refers to the degree of satisfaction consumers receive from consuming goods and services. These goods and services can consist of either the goods we need or the goods we want. Economists measure utility with a theoretical unit called the util. Generally, the more people consume, the higher their level of utility. This trend does not continue forever, however, as the law of diminishing utility eventually sets in. In other words, the gain we receive from consuming an extra good becomes less and less, as consumers have less of a need or want for the particular good.
When analyzing consumer preferences between two goods, economists measure utility with indifference curves. Consider a graph representing the quantity of apples on the X-axis and the quantity of oranges on the Y-axis. The indifference curve will then display a convex line bent toward the origin because consumers generally prefer a balance between goods. If a consumer had 10 apples, he would likely trade one for an orange. He would also probably trade two for an orange. However, with increasing trades for oranges, he would be willing to give away fewer and fewer apples for oranges. In sum, if he enjoyed apples and oranges equally, the customer would prefer five apples and five oranges over 10 apples.
Marginal Rate of Subsititution
The marginal rate of substitution measures the amount a consumer is willing to give up of one good to receive another good. When a customer faces two goods, a decreasing marginal rate of substitution sets in. This phenomenon occurs as a result of the law of diminishing marginal utility: Consuming more of one type of good becomes less and less satisfying. On the indifference curve, the marginal rate of substitution is measured by the slope of the curve. The negative, downward-sloping nature of the curve indicates a decreasing marginal rate of substitution.
The concepts of utility and indifference curves are highly theoretical and are difficult to apply to the real world. However, the concept of marginal rate of substitution has often been applied to various phenomena in economics. It has helped show the relationship between wages and worker effort, voting intentions and crime. Many economists have said that the marginal rate of substitution is a valuable concept in that it offers a comparative approach to analysis without the use of assumptions.