Importance of the Law of Substitution
The law of substitution is also known as the law of equi-marginal utility or the law of maximum satisfaction. This law was first developed by H.H Gossen. Therefore, this law is also known as second law of Gossen. Prof. Marshall has developed and given the present shape of this law.
This law is based on the following assumption:
- The consumer is rational.
- The utility can be measured in cardinal numbers.
- The marginal utility of money remains constant.
- Commodities are perfectly divisible.
- Income of consumer and prices of commodity remains constant.
The law of substitution is of great practical importance in economics which are given below:
1. Basis Of Consumption
Consumer is assumed to be rational. He always tries to maximize his utility subject to budget constraint. The law of substitution helps every consumer to maximize his utility by equalizing the marginal utilities obtained from different commodities.
2. Important In The Field Of Production
The law of substitution is also of great importance in the field of production. The producer has to use several factors of production in order to maximize net profit. For this purpose, he will substitutes one factor for another till their marginal productivity are made the same. For example, if the marginal productivity of one factor say labor, is greater than that of capital, he may substitute labor for capital. In this way, he will be able to maximize his profit.
3. Important In The Field Of Exchange
This law of substitution also applies in exchange, because exchange is nothing but the principle of substitution itself. When we sell a commodity say, sugar, we get money. With this money we buy another commodity, say, wheat.Therefore, we have really substituted sugar for wheat. We continue to substitute one factor for the other till their marginal returns from all factors are equalized.
4. Importance In Distribution
In the distribution, we are concerned with the determination of rewards of the various factors of production, i.e. determination of rent, wages, interest and profit.The use of each factors of production is pushed by the firm to a point where marginal productivity of one factor is equal of other factor’s marginal productivity. The law of substitute helps to equalize their marginal productivity.
5. Importance In Public Finance
The law of substitution is also applies in public finance. Government must try to maximize welfare of the community. For this, the government must down all wasteful expenditure where the return is not proportionate and instead divert the resources on more productive sector.
6. Price Determination
The principle of substitution is also applicable in the determination of prices when a commodity becomes scarce and its price becomes high. In order to bring its price down, we start substituting an abundant commodity for it, its scarcity will end.