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Marginal Rate of Transformation (MRT)

By MARSHALL HARGRAVE >>>>>>>>

✓✓ What Is the Marginal Rate of Transformation (MRT)?

The marginal rate of transformation (MRT) is the number of units or amount of a good that must be forgone to create or attain one unit of another good. It is the number of units of good Y that will be foregone to produce an extra unit of good X while keeping the factors of production and technology constant.

✓✓What the Marginal Rate of Transformation (MRT) Can Tell You

The marginal rate of transformation (MRT) allows economists to analyze the opportunity costs to produce one extra unit of something. In this case, the opportunity cost is represented in the lost production of another specific good. The marginal rate of transformation is tied to the production possibility frontier (PPF), which displays the output potential for two goods using the same resources.
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MRT is the absolute value of the slope of the production possibility frontier. For each point on the frontier, which is displayed as a curved line, there is a different marginal rate of transformation. This rate is based on the economics of producing the two goods.

Producing more of one good means making less of the other because the resources are efficiently allocated at points on the production possibility frontier. In other words, resources used to produce one good are diverted from other goods, which means less of the other goods will be created. This tradeoff is measured by the marginal rate of transformation (MRT). Generally speaking, the opportunity cost rises (as does the MRT's absolute value) as one moves along (down) the PPF. As more of one good is produced, the opportunity cost (in units) of the other good increases. This phenomenon is similar to the law of diminishing returns.

✓✓ Example of How to Use the Marginal Rate of Transformation (MRT)

The MRT is the rate at which a small amount of Y can be foregone for a small amount of X. The rate is the opportunity cost of a unit of each good in terms of another. As the number of units of X relative to Y changes, the rate of transformation may also change. For perfect substitute goods, the MRT will equal one and remain constant.

As an example, if baking one less cake frees up enough resources to bake three more loaves of bread, the rate of transformation is 3 to 1 at the margin. Or consider that it costs $3 to make a cake. Meanwhile, $1 can be saved by not making a loaf of bread. Thus, the MRT is 3, or $3 divided by $1.

As another example, consider a student who faces a tradeoff that involves giving up some free time to get better grades in a particular class by studying more. The MRT is the rate at which the student’s grade increases as free time is given up for studying, which is given by the absolute value of the slope of the production possibility frontier curve.

✓✓ The Difference Between the MRT and the Marginal Rate of Substitution (MRS)

While the marginal rate of transformation (MRT) is similar to the marginal rate of substitution (MRS), these two concepts are not the same. The marginal rate of substitution focuses on demand, while MRT focuses on supply.

The marginal rate of substitution highlights how many units of Y would be considered by a given consumer group to be compensation for one less unit of X. For example, a consumer who prefers oranges to apples may only find equal satisfaction if she receives three apples instead of one orange.

✓✓ Limitations of Using the Marginal Rate of Transformation (MRT)

The marginal rate of transformation (MRT) is generally not constant and may need to be recalculated frequently. Furthermore, goods will not be distributed efficiently if MRT doesn’t equal MRS.

✓✓ What is Elasticity

Elasticity refers to a measure of the sensitivity of a variable in accordance with another variable’s change. This way, one can measure the change in aggregate product demand with respect to price changes. In other words, it is called elasticity of demand. A product shall be termed as elastic if its demand varies more than the proportional amount of change in its price.

✓ To properly understand what is elasticity, we need to understand its working. In case the elasticity value exceeds 1.0, it's an indication that the product demand is more than proportionally getting impacted by a variation in price. This is what is meant by elasticity of demand. Here, the purchasing behavior of customers’ changes with a rise or fall in price.

If the value is below 1.0, it’s an indication that the demand has a relative insensitivity to price. This is an inelastic demand. Inelastic means that the product purchasing behavior of consumers does not change when the price rises. Similarly, the behavior does not change when the price drops.

Now, what is meant by elasticity = 0? This is a situation which is termed as 'perfectly' inelastic by economists. Here, at any price, the demand tends to stay the same. This is more like a theoretical concept at best because in the real-world such occurrences are extremely rare. Suppose this was the case in the real world, then it would mean customers would have a need to purchase products irrespective of the price charged.

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Classification of Cost

✓✓ What are Veblen Goods?

Veblen Goods are a class of goods that do not strictly follow the law of demand, which states that there exists an inverse relationship between the price of a good or service and the quantity demanded of that good or service. Veblen goods violate the law of demand after prices have risen above a certain level.

The Veblen Effect is the positive impact of the price of a commodity on the quantity demanded of that commodity. It is named after American economist and sociologist Thorstein Veblen, who studied the phenomenon of conspicuous consumption in the late 19th century.

✓ Consider the demand curve shown above. As the price of the commodity rises from P-A to P-B, the quantity demanded of the commodity falls from A to B. As the price of the commodity rises from P-B to P-C, the quantity demanded of the commodity falls from B to C. Between prices P-A and P-C, the law of demand holds, and there exists an inverse relationship between the price of a commodity and demand for that commodity.

However, for prices beyond P-C, the Veblen Effect dominates over the law of demand. As the price rises from P-C to P-D, demand increases from C to D. For all the prices above P-C, the law of demand does not hold, and there exists a positive relationship between the price of a commodity and demand for that commodity.

✓ Reasons for the Veblen Effect

1. Positional goods

Veblen goods are often positional goods. The quantity demanded of a positional good depends on how the good is distributed in society. Veblen goods often exhibit a negative positional effect, i.e., the quantity demanded of a Veblen good increases with a reduction in the distribution of the good. It occurs because the utility gained by a consumer from holding such a good arises purely from the fact that few other consumers hold it.
For example, the utility gained by a consumer from owning a diamond-encrusted handbag might arise primarily from the fact that few other people in society can afford to own such an object.

2. Perception of quality

In Veblen’s analysis of conspicuous consumption, the economist noted that for certain luxury goods and services, a higher price was often associated with the perception of higher quality. Therefore, a price increase was seen as evidence of the producer improving quality.

For example, the demand for a designer handbag rises with an increase in its price. The price increase is viewed by consumers as evidence that the producer of the designer handbag has improved the quality of the handbag.

✓✓ Economies of scale

Economies of scale are a reduction in costs to a business, which occurs when the company increases the production of their goods and becomes more efficient. This means that as businesses increase in size, it can lower their production costs and create a competitive advantage by either using those cost savings for increased profits or using the savings to lower the cost of their product to the consumer.

✓ The importance of economies of scale

Understanding economies of scale is important because of its effects on a business's production costs. Economies of scale create a competitive advantage for larger entities by putting out more production units and reducing their overall cost per unit. As companies increase their production, they can spread out both their variable and fixed costs over a larger number of goods, lowering the per-unit cost of the product. When this happens, consumers may also benefit from reduced costs of goods.

✓ Internal versus external economies of scale

1. External economies of scale

External economies of scale result from external factors outside the company's control, such as the industry, geographic area and the government. External economies of scale benefit cost reduction for the entire industry, not just for one company. These also typically create long-term effects for the entire industry, meaning everyone benefits in the long term and are harder to convert into short-term benefits.

2. Internal economies of scale

Internal economies of scale result from a company being able to cut costs internally because of the size of the company or internal decisions made by managers and executive leadership. Internal economies of scale result from internal factors such as bulk purchasing, hiring more efficient and highly skilled managers and using technological advancements to lower production costs. These often create immediate effects for an organization, which can develop these effects for increased long-term growth.

✓ Economies versus diseconomies of scale

Economies of scale result in lower production costs and production increases, diseconomies of scale result in higher production costs as production increases.

Diseconomies of scale can occur when a company becomes too large and tries to maximize the advantages of an economy of scale, but create inefficiencies that result in higher production costs. Diseconomies of scale can also occur because of internal factors such as an unskilled labor force, inefficient management and leadership decisions and a company culture where professionals are unmotivated.

When making a strategic decision to expand business, a company needs to balance the effects of economies of scale and diseconomies of scale to ensure the decisions it makes result in lower production costs and greater efficiency all around.

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CONCEPT OF UTILITY
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Utility, in economics, refers to the usefulness or enjoyment a consumer can get from a service or good. The economic utility can decline as the supply of a service or good increases.

The utility definition in economics is derived from the concept of usefulness. An economic good yields utility to the extent to which it's useful for satisfying a consumer’s want or need. Various schools of thought differ as to how to model economic utility and measure the usefulness of a good or service. Utility in economics was first coined by the noted 18th-century Swiss mathematician Daniel Bernoulli. Since then, economic theory has progressed, leading to various types of economic utility.
Credit: Investopedia

Accounting -An information System (part 1)

✓✓ What is Consumer Surplus?

Consumer surplus, also known as buyer’s surplus, is the economic measure of a customer’s excess benefit. It is calculated by analyzing the difference between the consumer’s willingness to pay for a product and the actual price they pay, also known as the equilibrium price. A surplus occurs when the consumer’s willingness to pay for a product is greater than its market price.

Consumer surplus is based on the economic theory of marginal utility, which is the additional satisfaction a person derives by consuming one more unit of a product or service. The satisfaction varies by consumer, due to differences in personal preferences. According to the theory, the more of a product a consumer buys, the less willing he/she is to pay more for each additional unit due to the diminishing marginal utility derived from the product.

✓✓ Consumer Surplus and the Price Elasticity of Demand

Consumer surplus for a product is zero when the demand for the product is perfectly elastic. This is because consumers are willing to match the price of the product. When demand is perfectly inelastic, consumer surplus is infinite because a change in the price of the product does not affect its demand. This includes products that are basic necessities such as milk, water, etc.

Demand curves are usually downward sloping because the demand for a product is usually affected by its price. With inelastic demand, consumer surplus is high because the demand is not affected by a change in the price, and consumers are willing to pay more for a product.

In such an instance, sellers will increase their prices to convert the consumer surplus to a producer surplus. Alternatively, with elastic demand, a small change in price will result in a large change in demand. It will result in a low consumer surplus as customers are no longer willing to buy as much of the product or service with a change in price.

✓✓ Assumptions of the Consumer Surplus Theory

1. Utility is a measurable entity

The consumer surplus theory suggests that the value of utility can be measured. Under Marshallian economics, utility can be expressed as a number. For example, the utility derived from an apple is 15 units.

2. No substitutes available

There are no available substitutes for any commodity under consideration.

3. Ceteris Paribus

It states that customers’ tastes, preferences, and income do not change.

4. Law of diminishing marginal utility

It states that the more a product or service is consumed, the lower the marginal utility is derived from consuming each extra unit.

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✓✓ THEORY OF CONVERGENCE (CATCH UP EFFECT)

Catch up effect, alternatively called the theory of convergence, states that poor or developing economies grow faster compared to economies with a higher per capita income and gradually reach similar high levels of per capita income. Thus, all economies, over time, may converge in terms of income per head.

This theory implies that the poorer nations grow much faster because of higher possibilities of growth and over time catch up with the richer countries in terms of per capita income such that the divide between the two gets minimized.

This theory of convergence of incomes is based on the logic of better opportunities of growth available for developing economies like access to technological know how from the developed world and increasing returns to capital, etc.

Empirical evidence suggests that while some developing economies have been able to effectively tap the available advantages to grow faster and catch up with robust economies, this has not been true for a large part of the developing world. The limitations of the theory are based on grounds of social, institutional or political differences, which simultaneously influence growth.

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✓✓ What is the Marginal Rate of Technical Substitution (MRTS)?

The marginal rate of technical substitution (MRTS) is the measure with which one input factor is reduced while the next factor is increased without changing the output. It is an economic illustration that explains the level at which one factor of input must decline. While maintaining the same level of production, another factor of production is increased. It shows how you can replace one input with another input without altering the resulting output.

✓✓ Understanding Marginal Rate of Technical Substitution

By substituting two input factors, the producer will need less amount of money to achieve an equilibrium where the firm realizes maximum profitability with minimum cost.

For example, the labor input can be decreased while the capital input increased with the production level remaining constant. The MRTS demonstrates the value by which one resource can be substituted with another input of production without altering the level of output.

✓✓ How MRTS Works

The marginal rate of technical substitution ascertains the amount of cost which a specific input can be replaced for another resource of production while maintaining a constant output. Therefore, the marginal rate of technical substitution explains when a producer is planning to replace one input of production with the next one.

The company may choose several combinations of inputs that can be alternatively substituted to produce the same level of output. The pair of inputs determined by the management must be able to achieve the best results.

For example, when factor A can produce a maximum quantity of output than factor B with the same cost incurred, the producer may end up choosing factor A instead of B

✓✓ The diagram below is an illustration of MRTS

In figure 1,

MRTSLK at point B = AE/EB

MRTSLK at point C = BF/FC

MRTSLK at point D = CG/GD

THE RATCHET EFFECT
suggests that when incomes of individuals fall, their consumption expenditure does not fall as much. This is partly because of the fact that people are conscious of the society they live in and do not want to show their neighbours that they can no longer afford to maintain their earlier standard of living and because they are accustomed to that level of consumption.
Further, this is also partly due to the fact that they become accustomed to their previous higher level of consumption and it is quite hard and difficult to reduce their consumption expenditure when their income has fallen. They maintain their earlier con­sumption level by reducing their savings. Therefore, the fall in their income, as during the period of recession or depression, does not result in decrease in consumption expenditure very much as one would conclude from family budget studies.

ILLUSTRATION
This is illustrated in Figure 7.2 where on the X-axis we measure disposable income and on the Y- axis the consumption and savings. Starting with disposable income of zero, we assume that there is steady growth of disposable income till it reaches Y1 .The linear consumption function CLR is the long- run consumption function. It will be seen from the figure that at Y1 level of disposable income, the consumption expenditure equals Y1C1 .Now suppose with initial income level Y1 there is recession in the economy with the result that disposable income falls to the level Y0.

According to Duesenberry, consumption would not fall greatly to the level Y0C0 as the long-run consumption function curve CLR would suggest. In their bid to maintain their consumption level previously reached people would now save less and reduce their consumption level only slightly to Y0C’0 whereas point C’0 is on the short- run consumption function curve CSR.

Since Y0C’0> Y0C0, the average propensity to consume at income level Y0is greater at C’0 than at C1 at income level Y1 (A ray drawn from the origin to the point C’0 will have greater slope than that of OC1). When the economy recovers from recession and dis­posable income increases, the economy would move along the short-run consump­tion function curve CSR till the consump­tion level C1 is reached at income level Y1. Beyond this, with the growth of income the consumption will increase along the long-run consumption function curve CLR.

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✓✓ Concept of Liquidity Trap

Liquidity trap refers to a situation in which an increase in the money supply does not result in a fall in the interest rate but merely in an addition to idle balances: the interest elasticity of demand for money becomes infinite. Under normal conditions an increase in money supply, resulting in excess cash balances, would cause an increase in bond prices, as individuals sought to acquire assets in exchange for money, and a corresponding fall in interest rates.

In such a situation, described by Keynes as liquidity trap, individuals believe that bond prices are too high and will therefore fall, and correspondingly that interest rates are too low and must rise They, therefore, believe that to buy bonds would be to incur a capital loss and as a result they hold only money. This means that an increase in the money supply merely increases idle balances and leaves the interest rate unaffected.

✓✓ Keynes pointed out that during depression when the rate of interest is very low, the demand curve for money (or the liquidity preference curve) becomes completely elastic (horizontal). The rate of interest has fallen enough. It cannot fall further.

The horizontal portion of the liquidity preference curve is referred to as the liquidity trap. In this portion of the curve, the demand for money is infinitely elastic with re­spect to the interest rate. Re­ductions in the interest rate, in this portion only, increases people’s desire to hold cash balances.

The implication here is that any attempt to achieve the internal expansion through increased investment brought about by lowering the interest rates would fall, because any increase in the money supply created in order to reduce the rate of interest would be held in the form of cash balances, making it impossible to use interest rates (monetary policy) to expand the economy. See Fig. 7 which describes such a situation.

✓✓ Keynes pointed out that the actual rate of interest cannot fall to zero because the expected rate cannot fall to zero. People’s expectations play a very important role in altering the rate of interest. Individuals’ views on the level of bond prices may be summarised in terms of their views about the interest rate.

Keynes’ theory assumes that each individual has his own view about the long-run equilibrium interest rate and that there corresponds to this a critical rate below which are individual holds only money and above which he holds only bonds. Clearly, if everyone is holding money as each one is in the liquidity trap then the current interest rate must be below the lowest critical rate situation.

However, in practice, there is no statistical evidence to support the existence of a liquidity trap. Furthermore, while the hypothesis rests on the view that expectations are regressive it offers no theory of precisely how these are formed.

THE RATCHET EFFECT
suggests that when incomes of individuals fall, their consumption expenditure does not fall as much. This is partly because of the fact that people are conscious of the society they live in and do not want to show their neighbours that they can no longer afford to maintain their earlier standard of living and because they are accustomed to that level of consumption.
Further, this is also partly due to the fact that they become accustomed to their previous higher level of consumption and it is quite hard and difficult to reduce their consumption expenditure when their income has fallen. They maintain their earlier con­sumption level by reducing their savings. Therefore, the fall in their income, as during the period of recession or depression, does not result in decrease in consumption expenditure very much as one would conclude from family budget studies.

ILLUSTRATION
This is illustrated in Figure 7.2 where on the X-axis we measure disposable income and on the Y- axis the consumption and savings. Starting with disposable income of zero, we assume that there is steady growth of disposable income till it reaches Y1 .The linear consumption function CLR is the long- run consumption function. It will be seen from the figure that at Y1 level of disposable income, the consumption expenditure equals Y1C1 .Now suppose with initial income level Y1 there is recession in the economy with the result that disposable income falls to the level Y0.

According to Duesenberry, consumption would not fall greatly to the level Y0C0 as the long-run consumption function curve CLR would suggest. In their bid to maintain their consumption level previously reached people would now save less and reduce their consumption level only slightly to Y0C’0 whereas point C’0 is on the short- run consumption function curve CSR.

Since Y0C’0> Y0C0, the average propensity to consume at income level Y0is greater at C’0 than at C1 at income level Y1 (A ray drawn from the origin to the point C’0 will have greater slope than that of OC1). When the economy recovers from recession and dis­posable income increases, the economy would move along the short-run consump­tion function curve CSR till the consump­tion level C1 is reached at income level Y1. Beyond this, with the growth of income the consumption will increase along the long-run consumption function curve CLR.

✓✓ Pareto Criterion of Social Welfare:
By Prof. R.K. Maheshwari >>>>>>>>

According to Prof. Baumol “any change which harms no one and which makes some people better off, this state of change must be considered to be an improvement.”

Suppose there are two persons A and B in a society and consume two goods X and Y. The various levels of their satisfaction by consuming various combinations of the two goods have been represented by their respective indifference curves.

In Figure 39.1, Oa and Ob are the origins for the utilities of two persons A and B respectively. Ia1, Ia2, Ia3, Ia4 and Ib1, Ib2, Ib3, Ib4 are their successively higher indifference curve. Suppose the initial distribution of goods X and Y between A and B is represented by point- K in the Edgeworth Box. Here K can be assumed as equilibrium point for both the persons in the initial stage.

Accordingly, individual A consumes OAG quantity of X + GK quantity of Y and is at the level of satisfaction represented by indifference curve Ia3. Similarly, individual B consumes KF quantity of X+ KE quantity of Y and gets the satisfaction represented by indifference curve Ib1. Thus the total given quantity of goods X and Y is distributed between A and B. In this distribution, individual A consumes relatively large quantity of good Y and individual B consumes more of good X. Now, it can be shown with the aid of Pareto’s welfare criterion that a movement from the point K to a point such as S or R or any other point in the shaded region will increase social welfare.

As shown in the diagram any change in the distribution pattern of two goods will definitely increase the satisfaction level of at least one person. If we move from K to S through redistribution of two goods between two individuals, it increases the level of satisfaction of A without any change in the satisfaction of B. Here A has been able to increase his satisfaction by moving to a higher indifference curve Ia4, whereas B remains on the same indifference curve Ib1 because K and S lie on same indifference curve Ib1 associated to B.

Thus, as a result of the movement from K to S, individual A has become better off whereas individual B is no worse off. Similarly, the movement from K to R is also desirable from the point of view of social welfare because in this individual B becomes better off without any change-in-the satisfaction of individual A. Therefore, both the positions S and R are better than K.

The tangency points of the various indifference curves of the two individuals of the society are the Pareto optimum points and the locus of these points is called ‘contract curve

𝗔𝘀𝘆𝗺𝗺𝗲𝘁𝗿𝗶𝗰 𝗜𝗻𝗳𝗼𝗿𝗺𝗮𝘁𝗶𝗼𝗻 (𝘚𝘶𝘮𝘮𝘢𝘳𝘪𝘻𝘦𝘥 𝘕𝘰𝘵𝘦𝘴)

✓✓ Economies of scale

Economies of scale are a reduction in costs to a business, which occurs when the company increases the production of their goods and becomes more efficient. This means that as businesses increase in size, it can lower their production costs and create a competitive advantage by either using those cost savings for increased profits or using the savings to lower the cost of their product to the consumer.

✓ The importance of economies of scale

Understanding economies of scale is important because of its effects on a business's production costs. Economies of scale create a competitive advantage for larger entities by putting out more production units and reducing their overall cost per unit. As companies increase their production, they can spread out both their variable and fixed costs over a larger number of goods, lowering the per-unit cost of the product. When this happens, consumers may also benefit from reduced costs of goods.

✓ Internal versus external economies of scale

1. External economies of scale

External economies of scale result from external factors outside the company's control, such as the industry, geographic area and the government. External economies of scale benefit cost reduction for the entire industry, not just for one company. These also typically create long-term effects for the entire industry, meaning everyone benefits in the long term and are harder to convert into short-term benefits.

2. Internal economies of scale

Internal economies of scale result from a company being able to cut costs internally because of the size of the company or internal decisions made by managers and executive leadership. Internal economies of scale result from internal factors such as bulk purchasing, hiring more efficient and highly skilled managers and using technological advancements to lower production costs. These often create immediate effects for an organization, which can develop these effects for increased long-term growth.

✓ Economies versus diseconomies of scale

Economies of scale result in lower production costs and production increases, diseconomies of scale result in higher production costs as production increases.

Diseconomies of scale can occur when a company becomes too large and tries to maximize the advantages of an economy of scale, but create inefficiencies that result in higher production costs. Diseconomies of scale can also occur because of internal factors such as an unskilled labor force, inefficient management and leadership decisions and a company culture where professionals are unmotivated.

When making a strategic decision to expand business, a company needs to balance the effects of economies of scale and diseconomies of scale to ensure the decisions it makes result in lower production costs and greater efficiency all around.