Substitution Effect: Definition & Example
What is the Substitution Effect
The substitution effect occurs when consumers switch to substitute goods as prices rise. For example, if the price of chicken increases, then consumers may start to switch to substitute goods such as beef or pork. This is because of the value consumers place on those good changes due to the price. For some, the higher price of chicken means that beef represents better value for money.
The substitute effect is not only applicable to consumers but also to businesses. For example, a supplier may increase prices which incentivizes the business to source their goods from elsewhere – perhaps a foreign competitor. In essence, the substitution effect represents the nature of supply and demand. When prices rise, demand falls, but rather than disappearing, that demand switches to substitute goods. However, it is important to note that this assumes that the price of substitute goods and other variables, such as quality, stay the same.
- The substitution effect occurs when consumers choose alternative goods as a result of a change in price.
- The substitution effect may not occur for inferior products as they are already the cheapest good available, so a price increase may not lead customers to alternatives.
Substitution and Income Effect
he substitution effect is also closely linked to the income effect, which allows firms to increase its prices without losing demand. For example, the price of a McDonalds increases by 10 percent. According to the substitution effect, consumers will go to a competitor such as Burger King – assuming its prices stay the same.
However, if incomes in the economy are rising, it could allow McDonalds the scope to capture some of that additional income through higher prices. For instance, as consumers disposable incomes rise, they are able to place greater value on their favourite goods. So although McDonalds might increase its prices by 10 percent, if consumers prefer it over Burger King, they will still shop there instead.
Substitution Effect and Inferior Goods
The substitution effect does not always occur – particularly for inferior goods. Such goods are inferior to its substitutes so an increase in price may mean that these goods are still cheaper than its substitutes. In some instances, consumers will have no option but to buy inferior goods as they are still cheaper than its comparable substitutes.
On occasion, these inferior goods may actually go against the normal supply and demand mechanisms. These are also known as Giffen goods. These goods actually see an increase in demand when prices increase. The phenomenon was noted by Sir Robert Giffen who found that the demand for potatoes actually increased in response to higher prices. The reason was that consumers on limited budgets had to pay more for potatoes which also meant they did not have enough for higher quality goods. The remaining income could only be spent on more potatoes instead, so the demand actually increases.
The substitution effect is where consumers choose alternative goods as a result of a change in price.
If PlayStation were to increase the price of its PS5 by $100, consumers may choose to purchase the cheaper alternative – an Xbox instead.
The income effect is where a change in price does not follow a decrease in demand. This is because incomes are rising which mean consumers can afford higher prices and may in fact purchase more at higher prices. By contrast, the substitution effect is where consumers choose alternative goods as a result of increasing prices.
Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.