Substitution Effect

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DEFINITION of 'Substitution Effect'

The idea that as prices rise (or incomes decrease) consumers will replace more expensive items with less costly alternatives. Conversely, as the wealth of individuals increases, the opposite tends to be true, as lower-priced or inferior commodities are eschewed for more expensive, higher-quality goods and services - this is known as the income effect.

INVESTOPEDIA EXPLAINS 'Substitution Effect'

Although beneficial to some (i.e. discount retailers), in general, the substitution effect is very negative in nature, as it limits choice. This is true not only for products, but also for services. Examples of the substitution effect in action can sometimes be observed over the winter holiday season, where, in lean economic times, discount retailers often hold up well.

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RELATED FAQS
  1. How can you calculate the substitution effect in Excel?

    The substitution effect is a principle in economics describing how consumers respond to price changes. Generally, increasing ... Read Full Answer >>
  2. Is the substitution effect negative for consumers?

    The substitution effect is both positive and negative for consumers. It is positive for consumers because it means that they ... Read Full Answer >>
  3. How do interest rate changes affect price elasticity in consumer discretionary goods?

    It's very difficult to estimate the interest elasticity of saving and spending, which is how the tendency to consume or save ... Read Full Answer >>
  4. How do you calculate the income effect distinctly from the price effect?

    Economists calculate the income effect separately from the price effect by keeping real income constant in the calculation. ... Read Full Answer >>
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    The first official proposal of market segmentation theory (MST) appeared in J.M. Culbertson's "The Term Structure of Interest ... Read Full Answer >>
  6. What's the difference between the substitution effect and the income effect?

    The substitution effect refers to consumers spending money on items of lower value, while the income effect refers to how ... Read Full Answer >>
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    Economics, like many academic fields, introduces ceteris paribus arguments when trying to demonstrate cause and effect. These ... Read Full Answer >>
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