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The substitution effect is an economic term used to describe consumer behavior relative to price or income changes.  For price, the substitution effect shows that as the price of a good or service increases, consumers will seek lower cost alternatives. Alternatively, as income decreases, consumers will seek lower priced goods to maintain their lifestyle.  Note also, as income increases, consumers may tend to purchase higher priced, thus presumably higher quality, goods and services.  This is known as the income effect. =

For sellers, particularly retailers, the substitution effect is negative. Consumers’ switching to lower priced goods means less profitability for sellers.  The only retailers who benefit are those retailers specializing in lower priced goods. 

The substitution effect does not apply exclusively to consumer transactions.  The corporate practices of offshoring and outsourcing are non-consumer examples of the substitution effect.  As labor costs increase in their home country, corporations tend to lower expenses by using cheaper labor in less developed countries.  Also, they may outsource jobs to third-party providers and independent contractors who perform the services less expensively than in-house employees. In these examples, the substitution effect is positive for the corporations, as they reduce costs, but negative for the replaced employees in their home countries.

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