MICROECONOMICS I General Equilibrium I MRS and MRT I Consumers and Firms

Marginal Rate of Substitution and Marginal Rate of Transformation

• In equilibrium, consumers trade goods until their willingness to exchange is the same, exhausting all possibilities of trading.
• The marginal rate of substitution (MRS) of an individual shows how much of one good they are willing to trade for one more unit of another good.
• The marginal rate of transformation (MRT) shows how much of one good producers must give up to produce one more unit of another good.

MRS and MRT in Equilibrium

• In equilibrium, the MRS of an individual equals the MRS of another individual.
• The MRT also equals the MRS in equilibrium, as producers adjust their production to satisfy demand.
• The MRS and MRT are equal to the price ratios in equilibrium, with the price of one good relative to the price of another.

Example: N's MRS and MRT

• Suppose N's MRS is 4, meaning she is willing to trade 4 units of food for 1 unit of clothing.
• The MRT is 2, meaning producers must give up 2 units of food to produce 1 unit of clothing.
• To give N 1 unit of clothing, producers must not produce 4 units of food, but instead produce 2 units of clothing, which is worth 4 units of food.
• This results in N getting 1 extra unit of clothing, which can be distributed between N and Bill.

General Equilibrium

• In a perfect market, companies produce until the last unit of production is covered by the price, meaning the price equals the marginal cost.
• The ratio of prices equals the ratio of marginal costs, leading to the point of equilibrium between the MRS and MRT.
• The general equilibrium is reached when the MRS for each consumer equals the MRT, meaning the willingness to exchange goods equals the capacity to produce them.
• This equilibrium point is the most efficient, as there is no better way to improve the economy, and the possibility for improvement is exhausted.