Marginal rate of technical substitution is a ratio indicating the amount by which one input can be substituted for another while keeping total output constant. It is best plotted visually on a graph and requires recalculation for each shift up or down the variable continuum. The objective is to find the point of production where the total combined units of labor and capital are minimized, saving the most cost.
Marginal rate of technical substitution is an economic term that indicates the ratio by which one input can be substituted for another, keeping total output constant. This allows analysts to identify the most cost-effective production method for a specific item, balancing the competing needs of two separate – but equally necessary – parts of components. Calculating this rate is most easily accomplished by plotting the input values on an XY graph in order to visually represent the rate of change across various possible input combinations. It is not a fixed value and requires recalculation for each shift up or down the variable continuum.
For example, it can be assumed that producing 100 units of product X requires 1 unit of labor and 10 units of capital. Calculating the marginal rate of technical substitution of labor will indicate how many units of capital can be “saved” by adding an extra unit of labor, keeping total unit output constant at 100. If 100 units of product X can be produced with two units of labor and only seven units of capital, the ratio of labor to capital is 3:1.
This number is specific to each specific set of input values. Although in this case – when moving from 1 to 2 units of labor – the rate of substitution is 3:1, this does not mean that it will remain 3:1 for all combinations of labor and capital. If producing 100 units of product X using three units of labor only requires five units of capital, the ratio has been changed to 2:1 for that particular labor/capital combination.
This specificity explains why the technical marginal rate of substitution is best plotted visually on a graph, using all possible combinations of labor and capital. It allows for quick visual consumption of variable rates across the entire possible spectrum of labor/capital combinations. This, in conjunction with the price information for the different component parts, allows one to quickly see which labor/capital combination provides the most economical method of producing a specific quantity of product.
When creating these calculations, it is necessary to assume that units of labor are equally expensive compared to units of capital. The objective becomes to find the point of production where the total combined units of labor and capital are minimized, saving the most cost. Continuing the previous example, in combination one, one unit of labor and 10 capital requires 11 units of labor/capital combined to produce product 100 of product X. Combination two, which consists of two units of labor and seven units of capital, drops to nine units, while combination three, which employs three units of labor and five units of capital, drops to seven. Combination three then becomes the most economical method of producing 100 units of product X.
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