What is the Substitution Effect?

Robinhood Learn
Democratize finance for all. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more.
Definition:

The substitution effect refers to the extent to which consumers switch to an alternative product in response to a change in the relative price of two or more goods.

Understanding a substitution effect

The substitution effect is a concept in microeconomics that describes how consumers substitute away from a given good — that is buy less of it and more of a substitute good — if its price increases. It is partially responsible for the law of demand (that is, the fact that people buy less of something as the price goes up). It is also a critical component of consumer choice theory, which explains how consumers make buying decisions. The substitution effect arises from the fact that people must choose between combinations of goods that fall within their budgets. If a product suddenly costs more, consumers will naturally look to buy substitute goods that are relatively cheaper.

Example

Imagine a child at Chuck E. Cheese trying to decide how to spend 100 tickets. For simplicity, assume there are only two prizes they can afford. There are Laffy Taffy for 10 tickets each and Ring Pops for 25 tickets each. Let’s say the kid picks five Laffy Taffy and two Ring Pops. However, when they get to the counter, they learn that the cost of Laffy Taffy went up to 50 tickets a piece. All of a sudden, they have to adjust their buying decision based on the new prices. Perhaps now they want no Laffy Taffy at this inflated price, so they buy four Ring Pops instead. The decrease in demand for Laffy Taffy from five to zero is the substitution effect.

Takeaway

The substitution effect is like commuting to work a different way to avoid a traffic jam…

Say you always take the same road to work. But one day, there’s a huge backup due to construction. You can still drive that way, but it will take much longer. So, you take a different road that’s not your normal route, but is unobstructed, to get to the office. Just as an increase in drive time (price) will make you choose an alternate route (a substitute good), the substitution effect will see you choose a good you don’t normally consume in response to a price increase.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.
Sign up for Robinhood
Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

Tell me more…

What is the substitution effect?

The substitution effect is all about how people change their purchases of one product in reaction to a price change of another good. Consider the following scenario. Ordering pizza costs $20, while Chinese food costs $25. At these prices, potential customers will weigh their preferences against these different prices. If someone orders Chinese food in this scenario, they are revealing that it’s worth the extra $5 for them. Now, imagine the Chinese food suddenly goes up to $30. If the customer doesn’t think the difference in taste is worth $10, they will buy the pizza instead. That’s the substitution effect.

How does the substitution effect relate to changes in demand?

The substitution effect is the change in demand for a good as a result of a change in its price. If a good’s price increases, compared to that of other substitute goods, demand for that good will go down. The substitution effect is one of two factors that contribute to the law of demand — which states that people buy less of a good as its price goes up. The other aspect is called the income effect, which captures the fact that changing prices alter the realm of possible combinations of products that a person can afford.

What is the price effect?

The price effect is the total change in consumption due to a price change. The price effect consists of the substitution effect and the income effect.

The change in price can be in the product itself or any other product that a consumer purchases. That is because consumers have limited funds, which constrains the combination of products a person can buy. People have to decide how to spend their money in a way that provides them with the most happiness — which economists call utility.

The price effect assumes that a person’s budget constraint doesn’t change, then observes how customers change their consumption patterns solely based on the effect of a change in price. That change in consumer choice is composed of two separate factors. First, the fact that the relative prices have changed (substitution effect). Second, the fact that the consumer can buy different combinations of items because of the price change (income effect).

Price effect = Substitution effect + Income effect

An example might help. Pretend you have $5 for lunch (your budget constraint), and your only options are a pizza and soda. A slice of pizza costs $2.50, and the vending machine charges $2.50 for a soda. You have precisely three possibilities:

  1. Two slices of pizza
  2. One slice and one soda
  3. Two sodas

If you want to buy a soda, you have to sacrifice a slice of pizza — That is called the opportunity cost. In this situation, perhaps you decide to get two slices of pizza and just drink water. Now, imagine that the price of a soda goes down to $1.25. All of a sudden, the opportunity cost of a slice of pizza is two sodas rather than one. Maybe now you decide to buy one piece of pizza and two sodas.

Notice that a change in the price of soda altered the amount of soda and pizza that you consumed. That’s the price effect —The change in opportunity cost (substitution effect) led to swapping a piece of pizza for a soda, and the extra $1.25 from that bundle (income effect) led to buying a second soda.

What is the difference between the income effect and the substitution effect?

While the substitution effect focuses on the change in relative prices, the income effect concentrates on what people do when their real income (the amount and combinations of goods they can buy) changes. For instance, imagine that you really like a jacket in the store window. You take it to the counter, expecting to pay $200 for it. In your mind, that $200 is already spent. If the cashier rings it up and tells you that it’s on sale for $150, it’s as if you just got handed a $50 bill. While you didn’t get a pay raise, your real income went up. What you decide to do with that $50 is called the income effect.

The substitution effect is all about how price-sensitive a consumer is. Economists measure the degree of substitution by looking at the cross price elasticity of two products — which is the extent that a price change in one product alters the demand for another. If one product is very similar to another product, it is called a close substitute. The closer the substitutes are, the larger the substitution effect will be.

Having close substitutes also results in a higher own-price elasticity (which measures the extent that a change in a product’s price alters the quantity of it that consumers demand). In simple terms, if the cost of a cup of coffee goes up, people might switch to drinking tea. The substitution of tea for coffee changes both the demand for tea and the quantity of coffee demanded.

How do you calculate the substitution effect?

Calculating the substitution effect requires you to isolate the impact of a change in relative prices. Changing the price of a good always forces the buyer to reevaluate the combination of goods that will maximize their utility (the total net benefits that something provides).

Microeconomic theory assumes that an individual is always attempting to maximize their utility function, subject to a budget constraint. Therefore, the consumer will seek out the combination of goods that provides the highest level of utility that they can afford. Changing prices alter those available combinations of goods and force consumers to find the new bundle, among the new set of possibilities, that provides the maximum utility.

However, the consumer chooses a new bundle based on both the updated relative cost (substitution effect) and the change in the total cost of a package at the altered price (income effect). That means calculating the substitution effect requires you to remove the income effect from the picture. Without going into the calculus, there are two ways to do that.

Imagine you have $100 to spend on breakfast for the office. You can buy doughnuts for $1 each or bagels for $2 each. These prices imply you can buy 100 doughnuts, 50 bagels, or some combination of each. Let’s just assume you end up bringing 50 doughnuts and 25 bagels to the office. Now, pretend that the price of bagels goes down to $1 apiece. Your set of options changes quite a bit. First, you now only have to trade one doughnut for a bagel rather than two. Second, if you bought the same bundle as before, you have $25 extra dollars to spend.

Calculating the substitution effect requires you to focus only on that former part of the puzzle, ignoring the question of what you would buy with the extra money. One way to do that would be to take that additional $25 off the table. To isolate the substitution effect, we could give you $75 (the cost of the old consumption bundle at the new prices) and see what you buy. That method is called the Slutsky substitution effect. If you walk through the door with 40 doughnuts and 35 bagels, the new price resulted in substituting 10 doughnuts for 10 bagels.

An alternative approach to calculating the substitution effect is the Hicksian method. Under this approach, we would force you to stay on the same indifference curve (all the combinations of goods that provide equal utility at different total costs). The Hicksian substitution effect is basically asking you to find the cheapest combination of goods at the new price, while providing the same level of utility as before.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

1330327

Related Articles

What is the Law of Demand?
Updated June 18, 2020

You May Also Like

The 3-minute newsletter with fresh takes on the financial news you need to start your day.
The 3-minute newsletter with fresh takes on the financial news you need to start your day.


© 2021 Robinhood. All rights reserved.

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC provides brokerage services. Robinhood Securities, LLC, provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. Robinhood U.K. Ltd (RHUK) provides brokerage services in the United Kingdom. All are subsidiaries of Robinhood Markets, Inc. ('Robinhood').

1476799