Question

Pick a point on an indifference curve for wine and cheese and show the marginal rate of substitution. What does the marginal rate of substitution tell us?

Short answer

The point on the indifference curve will be W* and C*.

The marginal rate of the substitution between cheese and wine at point X is given by

and is equal to 2.

The marginal rate of substitution between wine and cheese shows the trade-off rate at which wine will be substituted for the cheese.

Step-by-step solution

Explanation

The marginal rate of substitution is the rate at which the consumer will substitute the wine for cheese.

The point where the indifference curve intersects the budget line shows optimal bundle, i.e., point X.

Suppose the two goods, cheese and wine, are represented in the above diagram. The price of cheese and wine are $ 6 and $3, respectively, and the income is $3000.The intercepts at the X and Y axis are calculated by dividing the income by the price of the respective product, i.e., for wine 1000 units (=3000/3), and for cheese, 500 units (=3000/6).

Explanation

The marginal rate of substitution at the intersection of IC and budget line is equal to the relative price of two goods at the optimal bundle,

i.e., . The point X marked on the graph is where the wine is W* and cheese is C*; the marginal substitution rate will be 2 (=6/3). The marginal substitution rate says how much wine is to be given up to get one more pound of cheese.