What is the Substitution Effect?

The substitution effect is an economic concept based on how a change in the prices of goods or a change in income affects the number of goods demanded by consumers. When there is an increase in the prices of goods or decline in the income earned by consumers, their purchase trends change in such a way that they begin to substitute expensive goods for cheap products. In another vein, when consumers earn more income or prices of goods decrease, their appetite for luxurious goods resuscitate and they begin to substitute cheap products for expensive goods. This trend is described as the income effect.

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How does the Substitution Effect Work?

The substitution effect as a consumer choice theory reflects how consumption patterns and trends tend to change as a result of a change in the price of goods. Consumers replace expensive products for cheap products when there is a hike in the price of goods or when their income decreases. The same set of consumers are likely going to replace cheap products with luxurious and expensive ones when the prices of goods decrease or they get higher income. Products that substituted for another products, especially because they are cheaper are regarded as inferior goods. For example, when there is an increase in the price of a product and consumers see another product as a cheaper alternative that could probably serve the same purpose as the expensive one, the product is inferior. For instance, an increase in the price of rechargeable lamps can cause consumers to substitute rechargeable lamps for candles because they are cheaper, candles here are substitute goods. It is important to know that complementary goods are different from substitute goods, complementary goods have their needs attached to the purchase of another item. For instance, butter complements bread but not a substitute for bread.

Demand Curve of the Substitution Effect

Using a standard graph, the demand curve resulting from the substitution effect can pitched. On the graph, the Y-axis comprises of products A while the X-axis comprises of units of product B. Usually, the demand curve exhibited by these two axis develop a high downward slope movement in which there will be an increase in smaller slope as the units of product B rise. How consumers replace or substitute products when there is an increase in the price or decrease in income is graphically represented. The effect of the substitution on demand curve is also reflected.

Related Topics

• Market Structure
• Perfect Competition
• Bidding War
• Complements & Substitutes
• Substitution Effect
• Imperfect Competition
• Market Power
• Price Takers
• Price Makers 
• Perfect Competition and Decision Making
• X-Efficiency
• Captive Market
• Contestable Market Theory
• Highest Profit Point in a Perfectly Competitive Market
• Marginal Revenue
• Using Marginal Revenue and Marginal Costs to Maximize Profit
• Marginal Revenue Curve
• Profit Margin and Average Total Cost
• Break Even Point - Cost Curve
• Shutdown Point - Cost Curve
• Short-Run Decisions Based Upon Costs in a Perfectly Competitive Market
• Marginal Costs and the Supply Curve for a Perfectively Competitive Firm
• Long-Run Average Supply (LRAS)
• Decisions to Enter or Exit a Market in the Long Run
• Long-Run Equilibrium in a Perfectly Competitive Market
• Constant, Increasing, and Decreasing Cost Industries
• Productive and Allocative Efficiency in Perfectly Competitive Markets
• Market Efficiency
• Market Inefficiency
• Pareto Efficiency
• Market Failure 
• Search Theory
• Monopoly
• Natural Monopoly
• Legal Monopoly
• Bilateral Monopoly
• Promoting Innovation through Intellectual Property
• Predatory Pricing
• How Monopolists Set Price with the Demand Curve
• Total Cost and Total Revenue for a Monopolist
• Marginal Revenue and Marginal Cost for a Monopolist
• Inefficiency of Monopoly
• Perfectly Competitive Market
• Monopolistic Competition
• Duopoly
• Oligopoly
• Differentiated Products
• Perceived Demand for a Monopolistic Competitor
• Monopolistic Competitors Choose Price and Quantity
• Monopolistic Competitors and Entry
• Monopolistic Competition and Efficiency
• Cartel (Economics)
• Game Theory
• Traveler's Dilemma
• Prisoner's Dilemma
• Iterated Prisoner's Dilemma
• Nash Equilibrium
• Diner's Dilemma
• Trembling Hand Perfect Equilibrium
• Gambler's Fallacy
• Arrows Impossibility Theorem
• Backward Induction
• Tournament Theory
• Oligopoly and the Prisoner’s Dilemma
• Forcing Cooperation in a Prisoner’s Dilemma
• Cooperation and the Kinked Demand Curve
• Corporate Merger or Acquisition
• Antitrust Laws
• Herfindahl-Hirschman Index
• Concentration Ratio
• Other Approaches to Measuring Monopoly Power in an Industry
• Restrictive Practices under Antitrust Law
• Natural Monopoly
• Cost-Plus Regulation
• Price Cap Regulation
• Regulatory Capture