What it means
OpenStax Principles of Microeconomics explains that people typically buy less of a product when its price rises, for two reasons that can occur at the same time. The substitution effect occurs when a price changes and consumers have an incentive to consume less of the relatively higher-priced good and more of the relatively lower-priced one.
The second reason is the income effect, where a higher price reduces the buying power of income even though actual income has not changed. The key word is relative.
What drives the substitution effect is the price of one good compared with another, not the price on its own. If both goods double in price, the ratio stays the same and there is no pull toward either.
The size of the effect depends on how close the alternatives are. Two near-identical products, such as two brands of the same grade of fuel, allow a strong shift.
Goods with no close stand-in, such as a needed medicine, allow only a small one. Time also matters.
Over a short period, people may have few options and shift little. Over longer periods, they can find new suppliers or change habits, so the effect grows.
The substitution effect is why demand curves slope downward and why price elasticity of demand tends to be higher when good substitutes exist. It also explains business choices.
A firm that raises its price must expect some customers to switch to rivals, and a firm facing a costlier input may swap to a cheaper one. The effect is a concept, not a single number.
Economists separate it from the income effect in theory, but in real data the two usually appear together. Treat any exact split with care.
In practice
Real-world examples.
Example
A fictional household spends $200 a month on pizza at $10 each and sandwiches at $5 each, buying 10 pizzas and 20 sandwiches. Pizza rises to $20, so it now costs 4 sandwiches instead of 2. They buy 4 pizzas and 24 sandwiches, spending $80 plus $120, or $200.
Example
A fictional company uses either natural gas or electricity to heat a plant. When gas prices rise 30% and electricity stays flat, the firm shifts part of its heating to electric units. The relative price change drives the switch.
Example
A fictional traveller flies between two cities for $300 or takes a train for $120. When the fare rises to $450 and the train stays at $120, the plane now costs 3.75 trains instead of 2.5. Many passengers switch to rail on that comparison.
Formula
Calculation
Relative price of good A = Price of A / Price of B. Pizza at $10 and sandwiches at $5 gives 10 / 5 = 2; pizza at $20 gives 20 / 5 = 4.
The substitution effect pushes buyers away from the good whose relative price rose. In example 1, the pizza count fell from 10 to 4 and sandwiches rose from 20 to 24.
Worked example. A household has $200 a month to spend.
- Before: 10 pizzas x $10 = $100 plus 20 sandwiches x $5 = $100, so total spending is $200.
- After the pizza price rises to $20: 4 pizzas x $20 = $80 plus 24 sandwiches x $5 = $120, so total spending is still $200.
- Pizza fell by 10 - 4 = 6 and sandwiches rose by 24 - 20 = 4. This combined change includes some income effect, because the higher price also cut the buying power of the $200, so any exact split between the two effects is an estimate.Case study
Seen in the real world.
This case study is fictional and illustrative. A cafe sells coffee at $4 and tea at $3. When coffee beans become scarce and the price rises to $6, the relative price of coffee to tea goes from 1.33 to 2. Over the next month, coffee orders fall from 400 to 280 a week and tea orders rise from 200 to 260.
The owner sees that part of the loss is a switch to tea, a substitution effect. Some customers also cut back overall because their money buys less. She decides not to raise tea prices, to keep the switch going. She also adds a tea-and-pastry deal, since the closest substitute is the main source of her gain.
She also checks the weekly revenue. Coffee brings in 400 x $4 = $1,600 before and 280 x $6 = $1,680 after, while tea brings in 200 x $3 = $600 before and 260 x $3 = $780 after. Total weekly sales move from $2,200 to $2,460, even though coffee orders fell by 30%, because the price rise and the switch to tea both added revenue. The cafe and its figures are invented.
Watch out
Common mistakes.
- Treating the effect as a response to any price change, when it depends on the price of one good compared with another.
- Mixing it up with the income effect, when the second is about buying power and the first is about relative prices.
- Assuming every good has easy substitutes, when some needs allow only a small shift.
Questions
People also ask.
What is the substitution effect?
It is the shift toward a relatively cheaper good and away from a relatively costlier one when prices change. OpenStax describes it as an incentive to consume less of the higher-priced good. It is one of two effects of a price change.
How is it different from the income effect?
The income effect says a higher price reduces buying power, even though income has not changed. The substitution effect is about relative prices. Both can occur at once.
What makes it stronger?
Close substitutes and more time make it stronger. Goods with no good alternatives show a weaker response.
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