Substitution Effect

Refers to a change in the price of a good on the amount that a consumer demands

According to economics and particularly consumer choice theory, the substitution effect refers to a change in the price of a good on the amount that a consumer demands; the income effect arises from the change in the price of the good.

A related effect of the substitution effect is the decline in sales caused by increased costs for a product that leads consumers to choose less expensive alternatives. 

There is a general consensus that this occurs when the price of a good or service increases, but the buyers' income remains the same.

A price increase has no substitution effect when both goods are perfect complements.

Substitution Effect

In summary, it refers to why a consumer increases, decreases, or stops purchasing a product when its price increases or decreases relative to its substitutes. The intensity of the effect depends on how close the substitutes are to the original.

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.

Substitute Goods

A substitute good is a product that purchasers may exchange because of supply constraints or price considerations. 

Certain products may be easier to substitute than others. Substitute goods are two products that are used by the same consumers for the same purpose. 

The price of one of the products rises or falls, so the demand for the substitute good (if there is one) will rise or fall as well. The substitute products have a positive cross-elasticity of demand

For instance, substituting a tangerine for a mandarin would be better than swapping an apple for a tangerine, and swapping tangerines for chips would be even worse.

When it comes to snacks, tangerines and apples are examples of fruits that generally belong to the fruit category and are considered healthy snacks. In contrast, chips are an example of an unhealthy snack and typically belong to the junk food category.

Substitute Goods

Direct Substitute Goods

A substitute good is identical, similar, or comparable to another product in the eyes of the consumer. Customers can either fully or partly satisfy the same needs with substitute goods. Consumers, therefore, believe that they can be replaced. For example:

  • The Samsung s22 can be substituted for iPhone 12, and vice versa. The demand for the Samsung s22 will rise if iPhone 12 price rises.

  • People without access to a car can travel by bus or bicycle. As a result, buses and bicycles are substitute goods for cars.

  • If a product responds immediately to a change in price, it is a 'perfect substitute' or a 'close substitute.' 

However, if the cross-elasticity is small - where a 20% increase in the price of one product leads to a mere 1% increase in the demand for another, it is a 'weak substitute.'

  • A substitute product is one whose price rise results in an equal and immediate increase in demand for another. This is known as the cross-elasticity of demand.

  • Consumer preference determines what a 'perfect substitute' is. If Coke and Pepsi provide the same level of satisfaction, they are perfect substitutes. 

Pepsi can serve as a 'near-perfect substitute' for Coke, or vice versa if you prefer the taste of one over the other.

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.

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.

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.

Substitute Goods: Key Factors

It is shown that when the price of the iPhone increases, the demand for Samsung phones increases. When considering the power of substitution, price is not the only factor to consider. Several other factors must be taken into account.

When the variable changes, substitute goods satisfy consumer needs. When any of these parameters change, substitute goods come into play.

You might purchase a muffin every day from a local bakery. One day, you notice the quality of these muffins has diminished.

An important characteristic of high-quality muffins is that they have a thin, evenly browned crust. It has a symmetrical top, but it looks rough on top. It has a uniform texture, and it is light and tender when it is broken apart.

A muffin that is dry and dense is of poor quality. A muffin's quality drops when there is too much leavening. If too much baking soda or powder is in the batter, the muffin will rise temporarily, then collapse. Consequently, they become dense. 

As a result, you would like to replace your muffin with a doughnut or a slice of cake. The substitute good can be anything else that is purchased instead of the muffin.

There are many reasons why consumers choose substitutes. A few of them are listed below:

  • Price

Customers typically substitute goods because of the price. For example, a steak may be $20, and a plate of chips maybe $5 at a restaurant; the customer must believe that the steak is worth $15 more. 

We all assign different values to different items. As a result, the customer decides based on their desire to purchase one product over another. It is an unconscious decision. 

Price

  • Quantity

Consumers' decisions to purchase substitute goods are often influenced by quantity and supply. 

For example, three blueberry muffins might cost $10 at the grocery store. In contrast, a single muffin might be $4. Depending on the number of money shoppers have, they can choose either a smaller or a larger quantity of muffins. 

Quantity

  • Quality

Substitute goods can be in demand if the quality of the original product is low. During the decision process, one may consider whether a known product tastes better, lasts longer, or is more familiar. 

Local restaurants may serve decent food compared to well-known or branded restaurants. Both the quality and recognition factors need to be considered.

Quality

  • Geography

You may have a choice between two products. One may be sourced locally, and the other may be imported from abroad. Customer convenience is enhanced by the location, i.e., next-day delivery versus a longer delivery time. The customer will consider this as well when deciding on a product.

Geography

  • Tastes

The tastes of consumers can change over time. A product that is only available at certain times of the year may be a craze or a festive product. Winter could be spent enjoying hot soup; summer could be spent enjoying cool ice cream or fresh watermelon. 

Even though hot soup or ice cream can be substituted, its seasonality adds to its value to customers.

Tastes

  • Income 

Consumer behavior can be affected by income growth on a micro-level. Rather than making their coffee, consumers may get one from a coffee shop. 

Alternatively, as their incomes increase, they may start buying leaner cuts of steak. In a world of rising incomes, prices become less critical when considering substitute goods.

Income

Substitution Effect Examples 

Here are some more examples of substitution effects in economics:

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.

Milk

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.

Juice

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.

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.

Giffen Goods

Elite Modeling Package

Everything You Need To Master Financial Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Direct and Indirect Substitute Goods

Direct Substitute Goods

Direct substitutes have many characteristics in common. In the fast-food market, McDonald's and Burger King are direct competitors. They are also called 'close substitutes' or 'substitutes within their category.' 

There are many characteristics common to both direct substitutes and the original product, but the most important is that consumers can readily switch between the two.

Direct

A product's price is usually influenced by the prices of complementary and substitute products. The cross-elasticity of demand provides insight into the impact of the prices of these other products. There is a high cross-elasticity of demand for direct substitutes.

Whenever the price of one of the two products changes, the relationship between the two products is evaluated, and an indicator of price changes is used to determine whether demand for a product increases or decreases following price changes in another product. 

There may be branded fish fingers and a supermarket's own-brand fish fingers, for instance. Price changes may have a significant effect on customer preference.

The term cross elasticity of demand refers to an economic concept that measures how responsive one good is to changes in the price of another. Demand for goods that are direct substitutes is cross-elastic. 

According to the hypothetical scenario presented earlier, McDonald's sales will decrease due to their price increase, while Burger King's sales will increase. These two brands are directly competing due to their high correlation.

Direct Substitute Examples

  • Pepsi and Coca-Cola

  • Mcdonald's and Burger King

  • PlayStation and Xbox

  • Supermarket-branded and branded products

  • Travel by car or bus

  • iPhone and Android

  • Pizza Hut and Domino's

Indirect Substitute Goods

Indirect substitutes come from unrelated industries or categories. If the price of playing golf goes up, customers may start to play video games instead. Although they are different products and come from different industries, some customers may easily substitute them.

Different types of businesses compete against each other for the same market and customers.

Indirect

Suppose a customer walked into the store to buy a muffin, but none were available. Instead, the customer bought an apple. There are two completely unrelated items, but they can be substituted. There is a low level of cross-elasticity of demand for these products.

An elastic product has a quantity demand that changes more than proportionally as the price of the product changes. In contrast, if the quantity demand for a product is inelastic, the price change will not considerably change the quantity demand. 

The elasticity of demand for essential goods is low. Since electricity, gas, oil, and water are necessities rather than luxuries, they are relatively inelastic.  

Since indirect substitutes are not very common, their cross-elasticity of demand is low. Video game sales may only increase by 1 percent when the price of playing golf increases and sales decline by 10 percent. 

Thus, the relationship between the two is weak. Nevertheless, marketers should consider this.

In-direct Substitute Examples

  • Dancing and gardening

  • Golf and Video games

  • Muffins and apples

The Substitution Effect and Demand

Suppose the price of good D increases while the price of its substitute or substitutes remains the same or even decreases.

The demand for substitutes increases, while the demand for good D decreases. 

Consumers are paying attention to affordability, and they are looking for cheaper alternatives. In the case of products with few alternatives, such as inferior products or Giffen goods, this effect is minimal.

Substitution and Cross Elasticity of Demand

For a better understanding of substitute goods, we need to examine the economic concepts of demand and elasticity. 

As long as everything else is equal, the law of demand simply states that as the price of a good or service increases, the quantity demanded declines. This is not to say that demand for all goods is equally responsive to price changes.

Food and water, for example, do not respond as well to price as other goods, such as matchday tickets. While we cannot survive without food or water, we can survive without watching a soccer match. 

Price elasticity of demand measures how responsive demand for a product or service is to price changes. Price has little effect on demand, so demand is said to be inelastic. Conversely, if price affects demand significantly, then demand will be elastic. 

The degree to which one good can be substituted for another is determined by the cross elasticity of demand, which measures the responsiveness of demand for one product to price changes for another. 

If consumers switch to the cheaper product when the price of one product increases, there is positive cross elasticity of demand between the two products.

As the price of one of the products drops, the demand for the other product will drop as consumers once again turn to the cheaper product. Substitution occurs when one good's price changes relative to another or when one switches between goods.

Direct and indirect competition

There is indirect competition between products that are close substitutes, meaning that they serve the same customers. A frozen yogurt shop and an ice cream shop, for example, sell different types of products. 

Although they sell different types of products, they both cater to hungry people who are looking for something cold and sweet. This is what makes them indirect competitors. 

Another frozen yogurt shop near where the frozen yogurt shop in question is located also offers the same products. These two businesses are in direct competition with each other. 

Competition

For example, in several markets for commonly purchased goods, some products are interchangeable, yet they are branded and marketed differently. This is referred to as monopolistic competition.

Price

Think of a scenario in which there is an increase in the price of a cup of coffee from P1 to P2. In terms of the quantities consumed coffee from Q1 to Q2, there would be a decrease.

It is shown that the demand curve for tea - the substitute good - shifts out for all price levels, from D to D1, increasing its consumption over some time. 

Another example would be to compare the name brand and generic version of the same medication. Even though these two products are identical, they still have the same active ingredient. However, the packaging of the two products is quite different. 

A compound's active ingredients are those that are responsible for the biological or chemical effects of the compound. The products are identical because they contain the same amount of active ingredients. 

The only difference between the two medications is their price since the two products are essentially identical. In other words, both vendors rely mainly on branding and price to achieve sales.

Excel Modeling Course

Everything You Need To Master Excel Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Researched and Written by Saif Ali | LinkedIn

Reviewed and Edited by Sara De Meyer | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: