Loading the player...

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.

  1. Substitute

    A product or service that a consumer sees as comparable. If prices ...
  2. Inferior Good

    A type of good for which demand declines as the level of income ...
  3. Income Effect

    In the context of economic theory, the income effect is the change ...
  4. Normal Good

    An economic term used to describe the quantity demanded for a ...
  5. Marginal Rate of Substitution

    The amount of a good that a consumer is willing to give up for ...
  6. Cross Elasticity Of Demand

    An economic concept that measures the responsiveness in the quantity ...
Related Articles
  1. Insights

    Understanding the Substitution Effect

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

    What's a Substitute?

    A substitute is a good that satisfies the same needs as another.
  3. Insights

    Calculating Income Elasticity of Demand

    Income elasticity of demand is a measure of how consumer demand changes when income changes.
  4. Insights

    What Does Inferior Good Mean?

    The term “inferior good” does not describe a lack of quality, but rather, is an economic term used when discussing elasticity of demand for a good.
  5. Investing

    Calculating Cross Elasticity of Demand

    Cross elasticity of demand measures the quantity demanded of one good in response to a change in price of another.
  6. Investing

    What is the Income Effect?

    In economics, the income effect is the change in the consumption of goods caused by a change in income, whether income goes up or down.
  7. Insights

    What is Demand?

    Demand is the economic term for the cumulative wants and desires of consumers as they relate to a particular good or service. Generally speaking, if all other factors remain constant, as demand ...
  8. Investing

    Do Oil Prices Affect The Auto Industry?

    Based on an understanding of complementary and substitute goods, the American auto industry is exhibiting expected effects from the recent plunge in the price of oil.
  9. Insights

    Explaining Quantity Demanded

    Quantity demanded describes the total amount of goods or services that consumers demand at any given point in time.
  1. What's the difference between the income effect and the substitution effect?

    Learn more about the income effect and substitution effect in economics. Find out how these two principles impact consumer ... Read Answer >>
  2. What's the difference between the substitution effect and price effect?

    Learn how the increase in an item's price affects consumer demand. Explore the differences between the substitution and price ... Read Answer >>
  3. Should a small business test the substitution effect on its products before launch?

    Explore the substitution effect and find out how small businesses may evaluate how this principle impacts their own products. ... Read Answer >>
  4. How do you calculate the income effect distinctly from the price effect?

    Learn more about how the income and substitution effects operate in economics. Find out how to separate either of these while ... Read Answer >>
  5. What's the difference between the substitution effect and the income effect?

    Learn the difference between the income effect and the substitution effect in terms of spending money. Predict which direction ... Read Answer >>
  6. Is the substitution effect negative for consumers?

    Explore whether the substitution effect is positive or negative for consumers as well as for retailers, manufacturers and ... Read Answer >>
Hot Definitions
  1. Cash Flow

    The net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's ...
  2. PLUS Loan

    A low-cost student loan offered to parents of students currently enrolled in post-secondary education. With a PLUS Loan, ...
  3. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  4. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  5. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  6. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
Trading Center