The applications of this law of substitution in diversified fields of Economics are discussed here.
In the field of consumption, the law tells us as to how should a consumer spend his money to secure maximum utility. The law not only explains the number of units of various commodities to be purchased by the consumer, it also helps the consumer in allocating income of the consumer into multiple uses of the same commodity. Further, the decision regarding the proportion of income to be spent and the proportion to be saved too depend upon this law.
The distribution of budget between consumption and saving is the best in which the utility derived from the marginal unit of saving is equal to the utility derived from the marginal unit of consumption.
The law of equi-marginal utility can be extended to production. It becomes also important to the producer to maximise his returns. The producer combines the various factors of production in such a manner that marginal returns from the different factors of production are equalised.
The producer continues to substitute one factor for the other, till this objective is achieved. Through this, the producer ensures the optimal combination of the factors of production and is said to be in equilibrium.
Here, marginal productivities of all the factors of production are proportional to their respective prices. If there are ‘n’ factors of production, the following condition will be satisfied in the equilibrium:
MP1/P1 = MP2/ P2 = MP3/P3 = …………………. = MPN
where MP1, MP2, MP3,…………. MPN are the marginal products of various factors and P1, P2, P3………………….. PN are their respective prices.
In the case of inequality in the above equation, the producer will substitute the factor which gives him more productivity for the factor which gives him less productivity. This process of substitution will continue, till the ratios for the factors become equal.
The producer pays remuneration to the factors according to their marginal productivities. This is explained in detail under the theory of distribution. When the prices of different commodities are equal, the condition of equilibrium reduces to MP1 = MP2 = MP3 =………………………… = MPN.
The law of substitution is also applicable in the field of exchange, whether the exchange is of a good for a good, or of a good in exchange for money. Under barter system, where goods are exchanged for goods, the process of exchange continues, till the utility derived from the extra unit of the commodity consumed, becomes equal to the utility lost from the extra unit of the commodity sacrificed by the consumer. This condition is true for both the parties taking part in exchange.
When a consumer purchases a commodity for money, the process of exchange is in no way different from the case, which has been discussed under consumption in this sub-section.
4. Distribution and Price Determination:
We know that production is the result of joint efforts of different factors of production (i.e., land, labour, capital and entrepreneur. Their share in the production process (rent, wages, interest and profits) is determined according to the principle of marginal productivity.
The producer will employ various factors of production till the point, where the cost of employing each one of them equals their marginal productivity (or marginal revenue resulting from their use).
The law has an important bearing in the determination of value on the basis of their relative scarcity. More scarce goods command higher prices and vice-versa.
5. Public Finance:
The modern state is a welfare state, which undertakes various schemes for enhancing social welfare. The Government can realise the objective of public finance to achieve maximum social advantage through the law of substitution. The use of this law in the field of public finance is clear from the following two points:
(i) The welfare state has to push up public expenditure in various directions upto the point, such that the marginal utilities are equal in all of them to ensure maximum social benefit.
(ii) The rates of taxation should be devised in such a way that marginal sacrifices of all tax payers are equal.