Law of Substitution or Equi-Marginal Utility – Definition, Significance and Criticisms

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 states that in order to get maximum satisfaction, a consumer should spend his limited income on different commodities in such a way that the last dollar spent on each commodity yield him equal marginal utility.

The law of substitution  is also known as “The Law Of Maximum Satisfaction” because the consumer can maximize his/her satisfaction by spending income in accordance with this law. It is called “The Law Of Substitution” because the consumer will go on substituting one commodity with higher marginal utility for another commodity with lower marginal utility till the marginal utility of each commodity is equal. Suppose, there are two commodities X and Y on which a consumer has to spend a given income. If he finds that the marginal utility of commodity X is higher than the marginal utility of commodity Y, he will substitute the former for the latter till their marginal utilities are equalized.

Significance of The Law of Substitution

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.

Limitations of The Law of Substitution

The law of substitution has several limitations as follows:

1. Ignorance of Consumer: If the consumer is ignorant or blindly follows custom or fashion, he will make a wrong use of money. Due to his ignorance, he may not be aware of other more alternatives. In this case no substitution takes place and this law does not apply.
2. Commodities Indivisible: The law of substitution is based on the assumption that commodities are divisible and substituable. This is an unrealistic assumption. Though commodities may be divided according to the convenience of the consumer, it is not possible to divide all commodities in small units. There are certain commodities like fan or a radio which cannot be used in case of the indivisible commodities.
3. Utility not Measurable: This principle of maximum satisfaction is based on the unrealistic assumption of the cardinal measurement of utility and the constancy of the marginal utility of money.
4. Customs and Fashion: Sometimes people are slave of customs or fashion and they are unable to become rational.Without being rational a consumer cannot substitute one thing for another. This is another limitation of this law.
5. Unlimited Resources: The law of substitution has no place when the resources are unlimited as in the case of free gift of nature. In such cases, there is no need to re-arrange expenditure because they can be used without any cost.
6. Choice Uncertain: The alternatives open to the consumer also assumed to be certain. But consumer choices are uncertain and even risky. In fact, it is expected utilities that determine consumer’s choices of the various combinations he can buy with a given money income.