What Is the Substitution Effect?

The substitution effect is the decrease in sales for a product that can be attributed to consumers switching to cheaper alternatives when its price rises.

A product may lose market share for many reasons, but the substitution effect is purely a reflection of frugality. If a brand raises its price, some consumers will select a cheaper alternative. If beef prices rise, many consumers will eat more chicken.

Understanding the Substitution Effect

The substitution effect is not seen only in consumer behavior. A manufacturer faced with a price hike for an essential component may switch to a cheaper version produced by a foreign competitor.

In general, when the price of a product or service increases but the buyer's income stays the same, the substitution effect kicks in.

How, then, does any company get away with increasing its price? In addition to the substitution effect, there's the income effect. That is, some of its customers may be enjoying an increase in spending power and are willing to buy a pricier product.

A company's success in repricing its product is determined in part by how much of the substitution effect is offset by the income effect.

Key Takeaways

  • When a product's price increases, some consumers will switch to a comparable alternative. This is the substitution effect.
  • When a consumer's spending power increases, the income effect kicks in. They can spend more, and offset the substitution effect.
  • The Giffen goods principle suggests an exception: Cheap staples will actually rise in sales after a price increase because better choices are priced out of reach.

When Prices Decrease

As noted, when a product price increases consumers tend to drop it for a cheaper alternative. The can turn into an endless game of supply and demand. Steak prices rise, so consumers substitute pork. Demand for steak declines, so its price drops. Consumers return to buying steak.

This does not mean only that consumers chase a bargain. Consumers make their choices based on their overall spending power and make constant adjustments based on price changes. They strive to maintain their living standards despite price fluctuations.

The substitution effect kicks in when a product's price increases but the consumer's spending power stays the same.

The substitution effect is strongest for products that are close substitutes. A shopper might pick a synthetic shirt when the pure cotton brand seems too pricey. Enough shoppers may do that to make a measurable effect on the sales of both shirtmakers. If a golf club hikes its fees, some members may quit, but there may be no comparable choice for them to turn to. They may just give up golf.

The Substitution Effect and Inferior Goods

As illogical as it seems, the substitution effect may not be seen when the products that increase in price are inferior in quality. In fact, an inferior product that rises in price may actually enjoy a sales increase.

Products that display this phenomenon are called Giffen goods, after a Victorian economist who first observed it. Sir Robert Giffen noted that cheap staples such as potatoes will be purchased in greater quantities if their prices rise. He concluded that people on extremely limited budgets are forced to buy even more potatoes because their increasing price places other higher-quality staples altogether out of their reach.

Substitute goods may be adequate replacements or inferior goods. Demand for an inferior good will increase when overall consumer spending power falls.