Concept of Determine How Much of Household Investment Is Consumed

The theory of diminishing marginal rate of substitution relates to the pricing of marginal goods. The concept is well illustrated in the following figure. In this figure, the blue curve depicts the theoretical price of a good, and the yellow curve depicts the real value of the good purchased by a customer.

the diminishing marginal rate of substitution

Let us take a closer look at the second factor that enhances the usefulness of the concept of diminishing marginal rate of substitution. This factor is called implicit differentiation. According to the implicit differentiation, when a buyer of a good decreases his demand for a good, he shifts the location of his equilibrium point to a lower good. The reason for this is that in order to attain his equilibrium point, a buyer substitutes a good with some other good, which costs more than the good he first selected. The location of the equilibrium point is hence shifted from A to B according to the demand of the buyer. According to the Cobb-Douglas utility function, there is an implied relationship between the prices of goods measured on the market and the prices of such goods measured in terms of the inputs used to create them.

Assuming that the Cobb-Douglas utility function is valid, then the slope of the indifference curve must be equal to zero. Therefore, in the figure above, if the slope of the indifference curve is equal to zero, then the marginal rates of substitution between different goods are also equal. Let us see where the slopes of the indifference curves are found for various goods in the real world.

The slopes of the curves representing the diminishing marginal rate of substitution are equal for every equilibrium state until equilibrium is reached, at which point the consumer will prefer the good x over y if the price of the good x is greater than the cost of the goody. This means that when consumers find it difficult to obtain a good they usually prefer to substitute the good in with another good, which costs less. The price elasticity of demand is thus proportional to the slope of the curve representing the marginal significance of good x to the cost of goody. The more the demand for something is affected by the price of the same good, the lower its elasticity of demand will be. The smaller the elasticity of demand, the higher the price of the goody will have to be in order for consumers to obtain it.

It follows that if the prices of production of the goods decrease, i.e., they drop below the level associated with the level of total utility, the consumers will also decrease their consumption of the good, and the prices of production will fall below the level of total utility. Thus, it follows that a level of investment corresponds to a decreasing marginal utility of production and vice versa. If, on the other hand, the prices of production rise above the level associated with the level of total consumption, i.e., above the marginal value of production, i.e., above the consumers' marginal value of production, i.e., above the equilibrium level, there will be increasing consumption.

In this way, the concept of diminishing marginal rate of substitution between different goods can be understood. As long as the theory is well understood, it can help in solving problems of macroeconomics. A similar argument can be used to show that there is in general no tendency to increase the quantity of investment in a time of crisis. To illustrate this assertion, suppose a large increase in the price of some raw material occurs in the time of crisis, while at the same time the demand for such raw materials is increasing. According to the assumption, the quantity of investment will decline linearly according to the trend of the price of raw material against the value of consumption.

You can read about the diminishing marginal rate of substitution and mrts in economics on thekeepitsimple, and you can follow it for knowing more about the management.