Marginal Rate of Substitution

• Is an important tool of indifference curve

analysis of demand
• Rate at which the consumer is prepared to
exchange goods X and Y
• In the beginning, the consumer gives up 4
units of Y for the gain of one additional unit of
X and in this process his level of satisfaction
remains the same
• Follows that one unit gain in X fully
compensates him for the loss of 4 units of Y
• Means that at this stage he is prepared to
exchange 4 units of Y for one unit of X
• At this stage, the consumer’s marginal rate of
substitution of X for Y is 4
• The marginal rate of substitution of X for Y as the
amount of Y whose loss can just be compensated
by one unit gain in X
• Marginal rate of substitution of X for Y represents
the amount of Y which the consumer has to give
up for the gain of one additional unit of X so that
his level of satisfaction remains the same
• When the consumer moves from combination B
to combination C on his indifference schedule
he forgoes 3 units of Y for additional one unit
gain in X
• Hence the marginal rate of substitution of X for
Y is 3
• From C to D and then from D to E, the marginal
rate of substitution of X for Y is 2 and 1
respectively
 Principle of Diminishing Marginal Rate of
Substitution
• Marginal rate of substitution of X for Y
diminishes as more and more of good X is
substituted for good Y
• As the consumer has more and more of good
X, he is prepared to forego less and less of
good Y
Properties of Indifference Curve
 Indifference curve slope downward to the
right
• Indifference curve has a negative slope
• Has downward sloping means that when the
amount of one good in the combination is
increased , the amount of other good is
reduced
• This must be so if the level of satisfaction is to
remain the same on an indifference curve
• In the beginning the marginal rate of
substitution of X for Y is 4 and as more and
more of X is obtained and less and less of Y is
left, the MRSxy keeps on falling
• As the consumer’s stock of X increases and his
stock of Y decreases, he is willing to forego
less and less of Y for a given increment in X