Question

Explain why an MRS between two goods must equal the ratio of the price of the goods for the consumer to achieve maximum satisfaction.

Answer 1

Explanation:

The MRS describes the rate at which the consumer is willing to trade off one good for another to

maintain the same level of satisfaction. The ratio of prices describes the trade-off that the consumer

is able to make between the same two goods in the market. The tangency of the indifference curve

with the budget line represents the point at which the trade-offs are equal and consumer satisfaction

is maximized. If the MRS between two goods is not equal to the ratio of prices, then the consumer

could trade one good for another at market prices to obtain higher levels of satisfaction. For example,

if the slope of the budget line (the ratio of the prices) is 4, the consumer can trade 4 units of Y

(the good on the vertical axis) for one unit of X (the good on the horizontal axis). If the MRS at the

current bundle is 6, then the consumer is willing to trade 6 units of Y for one unit of X. Since the two

slopes are not equal the consumer is not maximizing her satisfaction. The consumer is willing to trade 6

but only has to trade 4, so she should make the trade. This trading continues until the highest level of

satisfaction is achieved. As trades are made, the MRS will change and eventually become equal to the

price ratio.