Maximizing Value Creation Through Maximizing Return on Investment (ROI)

 In economics, the marginal rate of substitution defines the rate at which consumers switching from one form of investment to another change their consumption from one form to another without changing their total income. The concept of marginal utility is well illustrated in simple terms by the following example. Assume that Bob wants to buy some milk. He saves $4.00 and visits the milk shop the next day to purchase some milk. Assuming that all purchases are made at the prevailing price level and that no other changes, such as Bob buying food or fuel, take place, then, based on the assumption that, after taking his new milk purchase, he will consume the amount he saved, and since he has changed from purchasing food to selling fuel, his income will rise.

The marginal rate of substitution could also be called the substitution value of income, since it is equal to the lowest common divisor of the quantity of time that it would take to substitute one commodity for another. The present-day United States economy is indeed a world of changes, and for each change, there must be an adjustment or a lag. For example, when households save money by changing from liquid investments like savings accounts and bonds to saving products like stocks and bonds, they must first wait for several weeks, if not months, before the saving will have sufficiently converted its form into a firm purchase price. Once saved money has reached a firm purchase price, then the purchaser of the stock or bond must wait for at least two years or more before that purchase price converts into income.

Let us now consider how this process of changing one form of investment for another takes place in the context of a marginal rate of substitution. Suppose, for instance, that Bob saves some money by buying wheat instead of using cash. Now suppose that when this change takes place, Bob's neighbour sells wheat to him for two dollars per bag. Then, because Bob has saved some money by purchasing the cheaper product, his investment income increases, from two dollars to four dollars. This increase, however, is offset by the lower sale price of the wheat, which lowers his capital cost (the difference between the higher price and the lower price). Because there are two goods affected, Bob must always choose the option with the highest marginal rate of substitution and since two of the possible choices are available, he chooses the option that gives him the largest return.

If we want to predict how market prices will vary over time, then we must use a technique called the indifference curve. The indifference curve depicts the tendency of prices to change with respect to a third variable, given by the existing price level. Let us denote this third variable X, by the symbol X(t), where t represents the time interval over which the equilibrium price is reached. The slope of the indifference curve depicts the rate of change of prices between the times t0 and tmax, where the greater the slope, the higher is the tendency for prices to change in equilibrium with respect to X.

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