Marginal Rate of Substitution: Definition, Formula & Examples

Marginal Rate of Substitution: Definition, Formula & Examples
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  • 0:02 What Is the Marginal…
  • 1:22 Use by Producers
  • 2:47 Differing Quantities
  • 4:21 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

The marginal rate of substitution helps firms figure out just how much substitution of goods they can get away with until consumers have had enough. From toilet paper to beer, this has an effect on everything.

What Is the Marginal Rate of Substitution?

Let's say you were at a fast food restaurant and were ordering lunch. When asked what you want to drink, you reply with the name of one of the big national beverage company's products to be told that this restaurant only carries their competitor. Most people just shrug their shoulders and go with the alternate, whereas some people will order something completely different. A small number of people will even bring in their preferred beverage!

In choosing to have one fizzy drink over another, you have just substituted your original choice for something you felt, for whatever reason, was a good replacement. If you're one of the people who doesn't make such an easy substitution, you've just demonstrated why substitution is never perfect. In any case, your reaction helps to determine the marginal rate of substitution, or a measure of the rate at which people will substitute one good for another.

Soft drinks at fast food places are a good way of explaining this concept because many of the most die-hard fanatics will begrudgingly accept their competitor's option. However, some don't. That means that the marginal rate of substitution for soft drinks in fast food restaurants is not quite 100%, but definitely close.

Use by Producers

Without knowing it, you make these sorts of substitutions daily, but they are very interesting to economists. Say you're in line at the sandwich place and your preferred brand of chips is absent. If you choose an option that is cheaper for the shop to stock, the company may decide to move towards phasing out the more expensive chips. By examining the marginal rate of substitution, producers can help to cut their costs substantially.

But what if consumers don't react well? Say that you were the owner of a college bar where the majority of your customers had a very defined preference for a certain type of beer. It's expensive to supply, so you decide that, since many college students just treat beer as beer, it won't be a big deal to replace that beer with a cheaper option. To you, the rate of substitution was 100% - you can't taste the difference.

Unfortunately for your bar, your customers can, and they miss the old stuff. The establishment next door takes the hint, advertises that it sells the beer that you discarded, and even raises its prices to be able to make a bigger profit. In other words, the rate of substitution among your student clients was closer to 0%. All the while, the best chicken fingers in town can't save you.

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