Substitution Effect

AAA

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.

VIDEO

Loading the player...
RELATED TERMS
  1. Marginal Rate of Substitution

    The amount of a good that a consumer is willing to give up for ...
  2. Substitution Swap

    An exchange that is carried out by trading a fixed-income security ...
  3. Indifference Curve

    A diagram depicting equal levels of utility (satisfaction) for ...
  4. Economics

    A social science that studies how individuals, governments, firms ...
  5. Asset Substitution Problem

    A problem that arises when a company exchanges its low-risk assets ...
  6. Duty Free

    Goods that international travelers can purchase without paying ...
Related Articles
  1. Economics

    Understanding the Substitution Effect

    The substitution effect is an economic term used to describe consumer behavior relative to price or income changes.
  2. Personal Finance

    Why We Splurge When Times Are Good

    The concept of elasticity of demand is part of every purchase you make. Find out how it works.
  3. Stock Analysis

    The Logic Behind Sears' REIT

    Learn what strategy Sears employed with the divestment of its 266 real estate properties to a separate real estate investment trust.
  4. Stock Analysis

    How Nike (NKE) Continues to 'Do It'

    Other than style, do sneakers from any maker really differ that much? That's debatable. But this is certain: Nike sets the standard for selling an image.
  5. Investing Basics

    Why You Might Buy Your Next Car from Costco

    Costco, one of the strongest retailers around, has its hooks in all sort of sectors, including autos.
  6. Professionals

    Are These the 10 Best Stocks in the World?

    Most of the top 10 stocks in the world have performed exceptionally well over the past several years. Here's a look at their future prospects.
  7. Stock Analysis

    Will Jet.com Revolutionize Shopping?

    Jet.com has arrived and will look to steal market share from Amazon over the next several years. Will it be successful?
  8. Economics

    Why U.S. Consumers Aren’t Spending

    Despite continued improvement in the labor market and lower gasoline prices, consumers' activity remains soft: retail sales growth is close to its lowest.
  9. Personal Finance

    Why Best Buy Failed in China

    Best Buy entered China with much fanfare in 2006. The Minnesota-based retailer exited quietly last year. What went wrong?
  10. Personal Finance

    Don't Underestimate Kroger's Retail Power

    The grocery chain Kroger has been growing stronger thanks to strategies such as holding down costs, acquisitions, and a focus on convenience.
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 >>
  5. Where did market segmentation theory come from?

    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 >>
  7. What are some examples of ceteris paribus arguments in economics?

    Economics, like many academic fields, introduces ceteris paribus arguments when trying to demonstrate cause and effect. These ... Read Full Answer >>
  8. How does the risk of investing in the metals and mining sector compare to the broader ...

    The metals and mining sector faces specific investment risks, such as highly capital intensive projects, regulatory changes, ... Read Full Answer >>
  9. How are major Internet service providers (ISP) preventing new startups?

    The Internet sector is a dynamic, fast-changing and increasingly competitive space. Even though some Internet service providers ... Read Full Answer >>
  10. Under what circumstances might price elasticity significantly change?

    Price elasticity of demand is an important concept in economics and price theory. The term "elasticity" refers to the sensitivity ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Nanny Tax

    A federal tax that must be paid by people who hire household help (a babysitter, maid, gardener, etc.) and pay them a total ...
  2. Dog And Pony Show

    A colloquial term that generally refers to a presentation or seminar to market new products or services to potential buyers.
  3. Topless Meeting

    A meeting in which participants are not allowed to use laptops. A topless meeting organizer can also ban the use of smartphones, ...
  4. Hedging Transaction

    A type of transaction that limits investment risk with the use of derivatives, such as options and futures contracts. Hedging ...
  5. Bogey

    A buzzword that refers to a benchmark used to evaluate a fund's performance. The benchmark is an index that reflects the ...
  6. Xetra

    An all-electronic trading system based in Frankfurt, Germany. Launched in 1997 and operated by the Deutsche Börse, the Xetra ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!