Author: Sarthak Bhalerao
Table of Contents
- What is Substitution Effect?
- Understanding substitution effect
- Practical example
What is Substitution Effect?
The substitution effect refers to the change in demand for goods and services as a result of a change in the price of the goods compared to that of other substitute goods. If the price of any good rises, the consumers tend to switch to its substitute. Any product may lose market share for many reasons, but the substitution effect is purely a result of frugality.
Understanding Substitution Effect
Whenever the price of a product or service increases but the buyer’s income stays the same, the substitution effect kicks in. This is evident in consumer behaviour. A manufacturer faced with a price hike for an essential component from a domestic supplier may switch to a cheaper version produced by a competitor.
John eats rice that costs $5 per pound and pasta that costs $10 per pound. The relative price of 1 pound of pasta is 2 pounds of rice. At their current prices, John consumes 1 pound of pasta and 2 pounds of rice.
Due to some technological advances in rice cultivation, there is a fall in rice prices from $5 a pound to $2 a pound. The relative price of 1 pound of pasta has now increased from 2 pounds of rice to 5 pounds of rice. Therefore, John switches away from pasta and into the rice. The change in consumption occurs purely due to the changes in the relative price of the goods and not because of a change in income.