What it means
Resources such as workers, machinery and materials are limited, so producing more of one thing means producing less of another. A furniture workshop with a fixed number of carpenters can make more tables only by making fewer chairs.
The MRT tells you how many chairs are lost for each extra table. The production possibility frontier, or PPF, is a curve showing the maximum combinations of two goods that can be made with the available resources.
The MRT is the slope of that curve at a point. If the curve is steep, the extra unit of one good costs a lot of the other.
For most businesses, the MRT is equal to the ratio of the marginal costs of the two goods. If an extra table costs $120 to make and an extra chair costs $60, the MRT of chairs for tables is 2, meaning the firm gives up 2 chairs in order to make one more table.
The ratio is the opportunity cost expressed in units of the other product. The MRT usually increases as production shifts further towards one good, because resources are not equally suited to both tasks.
The first carpenters moved to table-making are those best suited to it, but later moves involve workers who are less suitable, so more chairs are lost for each additional table. This increasing opportunity cost explains why the PPF bows outwards.
Managers use the idea to decide on product mix. The best mix is where the MRT equals the ratio of the selling prices of the two goods, since beyond that point switching production earns less than it costs.
The concept is also used by economists to analyse trade between countries. It links closely to comparative advantage.
A country or firm with a lower opportunity cost of making a good, meaning a lower MRT in that direction, is the natural specialist, and both sides can gain by trading.
In practice
Real-world examples.
Example
A farmer can plant wheat or barley on the same field. When shifting 10 hectares to wheat reduces barley output by 20 tonnes, the farmer sees the opportunity cost of the extra wheat. A rise in the wheat price would change the answer.
Example
A small factory uses one production line for two products. Switching one hour of line time from product A to product B gains 8 units of B and loses 12 units of A, an MRT of 1.5 units of A per unit of B. The planner compares this with the selling prices before changing the schedule.
Example
A government considers moving resources from consumer goods to defence production. Economists use the MRT to estimate how many consumer goods are given up for each extra unit of defence output. The estimate helps the ministers see the cost of each choice.
Formula
Calculation
MRT of good Y for good X = Marginal cost of X / Marginal cost of Y
Optimal product mix: MRT = Price of X / Price of Y
A workshop can make tables or chairs. The marginal cost of one more table is $120 and of one more chair is $60, so the MRT is $120 / $60 = 2, meaning each extra table means 2 fewer chairs. If a table sells for $300 and a chair for $100, the price ratio is $300 / $100 = 3, which is higher than the MRT of 2. Making one more table costs 2 chairs worth $200 in sales but earns $300, so the workshop gains $100 and should shift further towards tables until the two ratios match.Case study
Seen in the real world.
Tallis Bakery is an illustrative, fictional business that bakes bread and pastries in the same kitchen using shared ovens and staff. The manager noticed that adding 100 more pastries a day meant baking 150 fewer loaves.
That gave an MRT of 1.5 loaves per pastry. A loaf earned $4 in margin and a pastry earned $7, so the extra pastry earned $7 while the lost loaves cost 1.5 x $4 = $6.
In this illustrative story, the manager shifted a little more production to pastries, then stopped when the trade-off became less favourable. The example shows that the best product mix depends on both the production trade-off and the prices.
Watch out
Common mistakes.
- Ignoring opportunity cost and looking only at the cost of the product being made, which hides what is given up elsewhere.
- Assuming the trade-off stays the same, when the MRT normally rises as more resources move towards one product.
- Confusing the MRT with the marginal rate of substitution, which refers to consumer preferences and not to production.
Questions
People also ask.
What does an MRT of 3 mean?
Making one more unit of one good means giving up 3 units of the other.
Why does the production possibility frontier curve outwards?
Because resources are not equally suited to every product, so the opportunity cost of shifting rises.
How do businesses use it?
To choose the product mix that earns the most from limited resources.
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