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What is a Substitution Effect?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 27 October 2016
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    2003-2016
    Conjecture Corporation
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Sometimes known as a type of substitution swap, a substitution effect is a term used to describe how a price change affects the purchasing activity of consumers. This particular phenomenon is actually one of two distinct effects that may occur as the result of a price change. Typically, a substitution effect refers to situations in which the consumer is motivated to buy less of a high-priced product and replace it with a product that costs less.

One of the factors involved with a substitution effect is the assumption that the income level of the consumer does not change. Only the price has changed. The implication is that if the price had remained at the former level, the consumer would have no motivation to make a change, since he or she considered the former price equitable. Unlike income effect, where the consumer’s income does shift, this particular phenomenon focuses squarely on the impact of the price change in causing consumers to alter their purchasing habits so they continue to receive the same quantity without spending any more money.

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It is important to note that the substitution effect does not indicate consumers simply stop purchasing the higher-priced product altogether. Instead, they reduce consumption of that product while increasing consumption of the lower-priced product. While the small difference in price was not formerly enough to motivate the consumer to try the lower-priced product, the increase in the price of the favored product made the savings more attractive and prompted the change.

This is often related to budgetary restraints, in that consumers attempt to keep their spending within a specific range. For example, if the price of a particular brand of canned green beans increases from $0.75 US dollars (USD) per can to $1.00 USD per can, some consumers may be motivated to try a house or store brand that is priced at $0.50 USD. Rather than buying four cans of the higher priced product, the consumer purchases two cans of each brand, effectively offsetting the price increase and spending the same amount of money in order to acquire the same quantity of canned green beans.

Products do not have to be alike in order to trigger a substitution effect. All that is required is the need to partially replace usage of a product that now carries a higher price tag with one that costs less. This means that if the price of hamburger increases noticeably, a household may choose to reduce its consumption of beef from four nights a week to three, while increasing consumption of the more economical chicken. Another approach would be to increase the consumption of vegetables while reducing the use of meat in several meals throughout the week.

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