Substitution Effect

Understand how individuals adjust their purchasing behavior when faced with price fluctuations and discover the impact on demand for goods and services in the marketplace

Author: Adin Lykken
Adin Lykken
Adin Lykken
Consulting | Private Equity

Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. Prior to joining Berkshire Partners, Adin worked for just over three years at The Boston Consulting Group as an associate and consultant and previously interned for the Federal Reserve Board and the U.S. Senate.

Adin graduated from Yale University, Magna Cum Claude, with a Bachelor of Arts Degree in Economics.

Reviewed By: Matthew Retzloff
Matthew Retzloff
Matthew Retzloff
Investment Banking | Corporate Development

Matthew started his finance career working as an investment banking analyst for Falcon Capital Partners, a healthcare IT boutique, before moving on to work for Raymond James Financial, Inc in their specialty finance coverage group in Atlanta. Matthew then started in a role in corporate development at Babcock & Wilcox before moving to a corporate development associate role with Caesars Entertainment Corporation where he currently is. Matthew provides support to Caesars' M&A processes including evaluating inbound teasers/CIMs to identify possible acquisition targets, due diligence, constructing financial models, corporate valuation, and interacting with potential acquisition targets.

Matthew has a Bachelor of Science in Accounting and Business Administration and a Bachelor of Arts in German from University of North Carolina.

Last Updated:December 30, 2023

What Is The Substitution Effect?

The Substitution Effect, in economics and consumer choice theory, describes how a change in the price of a product affects the amount that consumers demand. In other words, it looks at how people shift their preferences when prices change.

When the price of a product goes up but the consumer's income remains the same, they might decide to buy less of that product and look for cheaper alternatives. This shift to more affordable options is what we call the Substitution Effect.

For example, if the cost of a particular item increases, consumers might choose to buy a similar but less expensive product instead. This decision to substitute a pricier item with a more affordable one is driven by the Substitution Effect.

This effect becomes more pronounced when the price increase makes the original product less attractive compared to its substitutes. If two products are very similar, a change in the price of one can significantly influence consumers' choices.

However, it's important to note that the Substitution Effect doesn't always occur. In cases where two goods are perfect complements (meaning they go hand in hand and are used together), a price increase may not lead to a shift in consumer preferences.

Key Takeaways

  • The substitution effect in economics refers to how consumers change their purchasing choices when a product's price shifts compared to substitute goods.
  • When a product's price rises, consumers often opt for more affordable alternatives, increasing demand for substitutes, known as the substitution effect.
  • Rising prices also reduce disposable income, leading to decreased demand, called the income effect.
  • Substitute goods are easily replaceable due to price or supply factors, exhibiting positive cross-elasticity of demand.

Substitution Effect in Microeconomics

This effect in microeconomics describes the change in quantity purchased with a change in the price of related products. When the price of a good increases, there will be two outcomes

  1. Since the good is relatively more expensive than alternatives, consumers will switch to other, now cheaper goods. This is called the substitution effect.

  2. Increasing prices reduce disposable income, which decreases demand. This is called the income effect.

On the other hand, a salaried worker can choose between working or enjoying leisure time.

  1. When wages increase, then work is deemed more profitable than leisure time. This is known as the substitution effect.

  2. A higher wage could, however, make it possible for him to live a decent life while working less. This is known as the income effect.

On the one hand, as wages rise, workers will work more because of an increase in rewards. While on the other hand, as a result of higher wages, workers will work fewer hours in order to maintain their income targets.

Understanding the Substitution Effect

In microeconomics, it reflects the income effect and the law of demand. In general, when income or product prices change, the demand for products changes as well.

The availability of substitute products, however, helps consumers survive these situations and discourages producers from charging excessive prices.

Two economists, Slutsky and Hick, each define substitution effects differently. In the former case, when the product price increases, the consumers' purchasing power or income also increases so that they can maintain their existing consumption pattern or enjoy more by moving to a higher indifference curve. 

By moving to another consumer equilibrium point on the same indifference curve, the latter concept explains satisfaction maintenance.

1. Slutsky substitution effect

The Slutsky substitution effect occurs when income changes in response to price changes so that a new budget line passes through the old consumption bundle but with the slope determined by the new prices.

If the consumer's optimal choice is on the new budget line, then consumption changes.

2. Hicksian substitution effect

According to the Hicksian substitution effect, price changes are accompanied by such a large change in income that the consumer is neither better off nor worse off than before; that is, he is brought back to the original level of satisfaction.

Substitution Effect Examples

Here are some more examples of substitution effects in economics:

Example 1: 

If goat's milk suddenly becomes more expensive, consumers accustomed to that product could switch to cow's milk. In the event the price drops, they may return to goat's milk consumption. 

When consumers commonly use substitute products, switching practices like this can change their spending patterns easily.

Example 2: 

During COVID-19, orange juice prices spiked because of its vitamin C content. An immunity-boosting property of orange juice led to higher demand during a time when a reduced workforce caused transportation bottlenecks.

The price increase affects people who can no longer afford orange juice but still require vitamin C. 

Therefore, they use lemon juice instead of orange juice since it is cheaper and contains more vitamin C.

Example 3: 

Suppose someone eats one McDonald’s burger a day. A burger at MacDonald’s costs $5, whereas a burger at Burger King costs $6. 

McDonald's increases the price of their burger to $9 while a $ 200-a-day worker's salary remains the same. That worker moves to Burger King. 

Due to the price hike for McDonald's burgers, consumer demand decreased, and the worker’s preference for Burger King burgers increased.

Burger King's and McDonald's hamburgers satisfy consumers by being served quickly and relatively cheaply. 

The price of Burger King's hamburgers directly affects the price of McDonald's hamburgers and vice versa. In other words, they satisfy the positive cross-elasticity component of substitute goods demand.

Example 4: 

Worker A makes $5 per hour stacking shelves in a supermarket. She asks for $10 an hour because she values her time more than money. In the supermarket, worker A is fired, and worker B is hired for $5 per hour. 

As worker A's labor price increased, her demand decreased, and the need for worker B, a close substitute, increased.

Consumers check the substitute product's price and buy the affordable alternative whenever a product's price rises. The effect is greater if substitutes are readily available and consumer income remains the same. 

The effect has little influence on items with few replacements, such as inferior goods or Giffen goods.

Researched and Written by Saif Ali | LinkedIn

Reviewed and Edited by Sara De Meyer | LinkedIn

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