Marginal Rate of Substitution

In the subject of microeconomics, the Marginal Rate of Substitution (MRS) is a very important concept that economists use for their calculations. This concept has been around since the days of the classical economists, and it is a tool that is still used in many different fields of calculation.

According to the classical economists, it is the amount of product A that a consumer is willing to give up, in order to obtain an additional unit of product B. The important part of this formulation is that the total utility derived by the consumer for product A and B remains the same.

An Example
This concept will become clearer with the aid of an example. Suppose a customer walks into a store and has $10 to spend. Now with these $10 he can buy 8 loaves of bread and 2 eggs. Assume that 1 loaf of bread costs $1 and 1 egg costs $1. Now if he wants another egg, he will have to purchase one loaf of bread less, but this will not affect his utility derived from the total purchase. He is thus sacrificing one loaf of bread for an additional egg.

Mathematically speaking, any combination of the amount of product A and product B that the consumer buys will result in the same amount of total utility derived. This can be represented on an indifference curve, which implies that the consumer will be indifferent if he purchases a lesser amount of product A, in order to get an additional unit of product B.

Importance
It clarifies that the resources that consumers have at their disposal are limited in nature. This means that the consumer has to make a choice between various goods. If he could obtain unlimited amounts of each product, this law would be useless in nature, but this is not feasible or realistic. Thus the concept of opportunity cost also arises in such a study.

Economists use the law of diminishing rate as a means to study consumer habits and their preferences. The products for which consumers are willing to sacrifice a greater number of alternative products, are more preferable to them. This helps economists study market trends, and it helps producers adjust the supply and the prices of that particular product.

A Calculation
In order to calculate it for a particular product in relation to another, there is a specific formula at our disposal. The formula is as follows.

MRS = Change in product A/Change in product B

According to our example, the change in the number of loaves is -1, and the change in the number of eggs is 1.

MRS = -1/1 = -1 = 1 (NOTE: The sign is ignored for the sake of convention)

Diminishing marginal rate of substitution exists because of the law of diminishing marginal utility. According to this law, the more units of a particular product that a consumer purchases, the lesser utility and satisfaction he derives. Thus in our example, the consumer will be less willing to sacrifice more units of bread in order to gain a greater amount of eggs.

This is not an exact science and it is simply a theoretical way of measuring this phenomenon. In reality, there are hundreds of different factors that play a part in a consumers decision-making process, so this formula cannot be relied on in such a simplistic form. Moreover, these reasons will be different for each individual consumer or firm, so it would be impossible to arrive at some standardized form of accurate calculation.

Its importance is to simply help economists and producers understand the concept of opportunity cost. It also helps them realize the dilemma that consumers face when they have to make a choice between two different products.