Substitution Effect

The substitution effect refers to a concept in economics that interprets why a consumer increased, reduced, or stopped buying a certain product when its price increased or decreased compared to its substitutes. The intensity of the effect depends on how close the substitutes are.

One example is that consumers who are used to soy milk may switch to cow milk if the price of soy milk increases abruptly. Conversely, they may return to soy milk consumption later if the price drops. This kind of switching practice changing the consumer spending pattern is easy when substitute products are common.

• The substitution effect in microeconomics explains the change in the purchased quantity of a product in relation to the change of price in related goods. 
• Slutsky and Hick's substitution effect are the two diverse definitions explaining the concept.
• When the price of a product rises, consumers check the substitute product price and buy the affordable product. 
• The effect is stronger if close substitutes are available and consumer income remains the same. When it applies to items with few replacements, such as inferior goods or Giffen goods, the effect's influence is low.

Substitution effect in microeconomics reflects the essence of income effect and law of demand. Along with the income effect, it explains the price effect concept in economics. Fundamentally, when income or product price changes, the demand for products changes. However, the availability of substitute products helps the consumers survive these situations and dissuade the producers from making an abnormal profit.

The above graph presents the substitution effect. Consider product A and product B substitutable to each other. Then, the consumer buys a combination of products A and B. The indifference curve represents its satisfactory combinations and tangent to the budget line. At the current purchasing power, the line MM₁ represents the budget line tangent to the indifference curve at CE₁ (X₁, Y₁), the consumer equilibrium point. Therefore, it indicates maximum satisfaction; consumer purchases X₁ quantity of product A and Y₁ quantity of product B.

When the price of product B rises and product A price remains the same, the budget line rotates, forming a new budget line NN₁. The new line tangent to the same indifference curve at CE₃ (X₃, Y₃). It indicates that in reaction to the price rise, the consumer reduced the quantity of product B and increased the quantity of product A. Therefore, the new combination falls in the same indifference curve. Hence enjoying the same level of satisfaction. Furthermore, a new budget line, M₁M₂, can emerge due to the income effect. When income increases, consumers move to a higher indifference curve (IC₂), showing greater affordability. 

Slutsky and Hick's substitution effect in macroeconomics is the two distinct definitions for the concept. The former signifies that when the product price increases, the purchasing power or income of the consumers also rises to enable them to maintain the existing consumption pattern or enjoy more by moving to a higher indifference curve. The latter concept explains satisfaction maintenance by moving to a new consumer equilibrium point in the same indifference curve.

Let's look into a few substitution effects examples in economics:

Jeff drinks orange juice every day for its vitamin C. During Covid 19 pandemic, the prices of orange juice spiked sharply. It is because the demand for orange juice increased due to its immune-boosting properties and at the same time faced supply bottlenecks due to restrictions in transportation and production issues due to reduced workforce during the pandemic. Because of the price rise, Jeff can’t afford orange juice anymore but still needs his vitamin C. So he starts buying lemon juice instead, which contains vitamin C and is now cheaper than orange juice.

James loves Mcdonald's and eats one burger every day. He makes $100 per day, and a burger at Mcdonald's costs $5, while a burger at the nearby Burger King costs $6. McDonald's decides to increase the price of their burger to $9 while James's salary remains the same. James starts buying burgers from Burger King instead. When the price of the McDonalds burger increased, the consumer demand for it decreased, and his demand for the cheaper alternative, the Burger King burger, increased.

Jake pays Jim $5 per hour to stack shelves in his store. Jim decides that his time is more valuable and asks for $10 per hour. Jake fires Jim and hires Steve, who agrees to work for $5 per hour. When the price of Jim’s labor increased, the consumer Jake’s demand for it decreased, and his demand for the close substitute, Steve’s labor, increased.

When the price of a good G increases and its substitutes price remains the same or is lower than G's, the demand for substitutes increases, and the demand for good G decreases. It is because ordinary consumers emphasize affordability and hence look for cheaper alternatives. However, the effect's impact is minimal for products with limited substitutes like inferior goods or Giffen goods. Altogether, the study of substitution effect in microeconomics is relevant to businesses for effective decision making.

This has been a guide to what is the Substitution Effect in Economics and its definition. Here we explain how the substitution effect affects demand along with examples and graphs. You may also have a look at the following articles to learn more –

• Substitution Effect vs Income Effect
• Microeconomics
• Autarky