Substitution Effect

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What is the 'Substitution Effect'

The substitution effect is the economic understanding that as prices rise — or income decreases — 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, known as the income effect. Although beneficial to some companies like discount retailers, the substitution effect is generally very negative within an economy, as it limits consumer and producer choice.

BREAKING DOWN 'Substitution Effect'

The substitution effect is meant to represent the change in macroeconomic consumption patterns that arise due to a change in the relative price of goods. Consumers have the tendency to replace, or substitute, luxury items with cheaper alternatives when income decreases or prices increase. Conversely, the same consumers tend to substitute low-cost alternatives with higher-priced goods when income increases or as the price of luxury goods decreases.

Goods are services that customers consume when relative prices increase are considered substitute goods. For example, when the price of red meat increases above the price of chicken, consumers are more likely to substitute red meat consumption with chicken consumption. The demand of red meat subsequently declines, and the demand for chicken increases. In this case, the chicken is a substitute good.

Some substitute goods can also be considered inferior goods. An inferior good is a product that has its demand increase when the relative price of another good increases. A bus pass, for example, will increase in demand when the relative price of cars increases. Therefore, a bus pass would be both a substitute good and an inferior good. When relative prices decrease or income increases, the demand for inferior goods decreases.

Substitute goods are not to be confused with complementary goods, which have demand that links to another, similar good. A complementary good, using the example above, would be a chicken marinade that increases in demand when the demand for chicken increases.

Demand Curve of the Substitution Effect

The substitution effect is depicted by a standard graph with "units of product A" on the Y-axis and "units of product B" on the X-axis. The demand curve between the two products is concave, meaning that it has a high downward slope initially and an increasingly smaller slope as the units of product B increases along the X-axis.

A price-sensitive consumer might, for example, stop consuming five units of product A initially and only replace it with one unit of product B. As the consumer continues to substitute more of product A with product B, however, the quantity demanded for each unit of product B will increase relative to a single unit of product A, smoothing the slope of the quantity demanded.