The substitution effect, which is due to consumers switching to cheaper products as prices increase, can be both positive and negative for consumers. The substitution effect is positive for consumers since it means that they can continue to afford a particular product even if prices increase or their incomes decline.

However, the substitution effect isn't always positive for consumers, but instead, can be negative since it can limit product choices. The substitution effect is typically negative for most companies that sell products since it can prevent them from raising their prices and earning higher profits.

Key Takeaways

  • The substitution effect states that as prices rise, or incomes fall, consumers replace more-costly goods with cheaper alternatives.
  • The substitution effect measures the change in spending patterns of consumers when there's a change in price.
  • The substitution effect can be positive for consumers since they can continue to buy the products they love even if prices have risen.
  • The substitution effect can be negative for consumers if it results in fewer choices of that product or the alternatives are of lower quality.

How the Substitution Effect Works

The substitution effect is a concept holding that as prices increase, or incomes decrease, consumers replace more-costly goods and services with less-expensive alternatives. When used in analyzing price increases, it measures the degree to which the higher price spurs consumers to switch products, assuming the same level of income.

For example, if the price of a premium brand of fruit cocktail rises, consumer spending will increase for supermarket house brands of fruit cocktail. The substitution effect also applies to buying patterns across brands and even across categories of consumer goods and services. If the price of all fruit cocktail brands goes up, some consumers will buy a less-expensive type of canned fruit instead, such as peaches. If the prices on all canned fruit start to soar, some consumers might switch to fresh fruit.

The substitution effect has a greater impact on products where there are alternatives that are close substitutes.

Substitution Effect and Consumers

The substitution effect is positive for consumers since they can continue to buy the products they love even if a major producer in the category raises its prices or perhaps the consumer loses their job. However, in testing the substitution effect, a company might be dissuaded from going to market with an innovative new product. As a result, there would be fewer choices for that product, which would be negative for consumers. Also, lower-priced alternatives can sometimes result in a lower quality product, which would also limit consumer choices if they wanted a high-quality product.

Substitution Effect and Companies

The substitution effect is negative for companies that sell products since consumers can go elsewhere for the product. As a result, the substitution effect limits a company's pricing power or ability to raise prices. The effect can decrease profitability for companies if a lower-priced alternative is gaining market share, meaning it's stealing a greater percentage of the industry's customers.

Companies can analyze their pricing strategies for their products by understanding the impact that the substitution effect has on their customers. As a result, companies can pinpoint the price level that triggers their customers to switch to a cheaper product. From there, companies could improve their product, lower their price, or offer add-on services to entice and prevent their customers from switching to the lower-priced alternative.

However, there are exceptions where certain types of businesses benefit from the substitution effect. For example, discount retailers and manufacturers specializing in low-end merchandise would gain customers if a competitor raised their prices. Typically, during years of slow economic growth or a recession, meaning negative growth, discount retailers tend to see their revenue rise or hold up relatively well versus other companies that sell full-priced products.

Examples of the Substitution Effect

Below are some common examples of the substitution effect in the economy.

  • Beef prices rise and consumers respond by purchasing more turkey or chicken.
  • Premium coffee prices at a coffee shop rise, and consumers respond by buying store brand coffee.
  • Price increases in designer pharmaceutical drugs lead consumers to buy generic alternatives.
  • Consumers who drink orange juice for its vitamin C witness an increase in OJ prices due to a crop failure and respond by buying cranberry juice.