The substitution effect is both positive and negative for consumers. It is positive for consumers because it means that they can afford to keep consuming products in a category even if their incomes decline or some products rise in price. It is also negative because it can limit choices. The substitution effect is negative for most companies that sell products, since it can prevent them from raising their prices and earning higher profits.
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 will switch to fresh fruit.
It is positive for consumers that they can continue to enjoy fruit if they lose their jobs or a major producer in the category raises its prices. However, in testing the substitution effect, a company might be dissuaded from going to market with an innovative new canned mixed fruit product. This would be negative for consumers because it would limit their choices. Moreover, sometimes but not always, lower-priced alternatives are lower in quality, also limiting consumer choices.
The substitution effect is negative for companies that sell products except for certain types of businesses, such as discount retailers and manufacturers specializing in low-end merchandise. During years when the economy is lean, discount retailers often tend to hold up relatively well.