In economics, the term “marginal rate of substitution” refers to the rate at which an individual can trade away some value in order to receive another of equal or higher value in exchange. At equilibrium, marginal rates of consumption are equal. A common example of this process is when you buy a product with your money and then decide to purchase something else that’s cheaper; you’d trade off your money and your good is no longer available. If the goods market were perfect, the situation would be described as the zero bound on prices.
In the case of the U.S. dollar, the zero bound on prices describes the range of price changes that a buyer and seller can expect when exchanging money for another product. As the name suggests, there is a minimum rate of substitutability that a buyer can obtain by trading his or her money for goods on an open market. If the buyer and seller have no knowledge of that minimum rate of substitutability, they will not be willing to exchange their money.
The marginal rate of substitution can also be referred to as the price elasticity or wage elasticity of demand. Basically, when a buyer and seller enter into an exchange transaction, they are expected to exchange exactly the quantity of money, whether it’s one dollar fifty cents or a whole dollar. However, when the goods market is imperfect (i.e., has imperfect information about the actual quantity of money and the actual quantity of goods that can be exchanged), buyers and sellers may be willing to trade away some of their good at higher or lower prices (depending on their knowledge of the actual quantity of money and the actual quantity of goods that are available to be exchanged for them).
In the United States, most goods have a minimum level of price elasticity, and the difference between the minimum and the actual level of price increases the potential for price changes in the goods market. So, if you purchase a particular good from a retailer at a certain price, you might still have that item at a higher value (i.e., the amount you pay for the good) despite a price drop in the goods market.
A related concept that is related to the notion of the marginal rate of substitution in economics is called the substitution of good for good. In the case of goods like gasoline or food, if you buy them for a high price but then trade them away to buy other goods (in the case of gasoline) or consume less of them (in the case of food), the net effect of the transaction on the good’s total quantity of use remains the same.
In a perfect goods market, the quantity of good buyer purchases will remain constant or increase even if the quantity of good that is traded away decreases. A perfect goods market is the perfect setting in which there is perfect competition between buyers and sellers. There will always be two or more products available, and buyers will only have to choose the best alternative that offers the largest possible benefit (a good will still sell when a better alternative exists at a given cost).
In the perfect goods market, however, consumers are not able to anticipate what the future will bring and hence they will never know the future price of good or goods. In a perfect goods market, people must buy goods for a long time and sell them at a lower cost.
The marginal rate of substitution can be seen in the food and gas market as a manifestation of the fact that the price of a commodity will not change unless the demand for the good is reduced (a drop in the demand for that commodity); when the supply of the good does not increase and the demand for it increases, so does the price. However, in the case of gasoline, the market cannot function in this way because the price will increase only when the demand for it is increased.