What is the substitution effect?
The substitution effect is the decrease in sales of a product that can be attributed to consumers switching to cheaper alternatives when its price increases. A product can lose market share for many reasons, but the substitution effect is only a reflection of frugality. If a brand raises its price, some consumers will choose a cheaper alternative. If beef prices rise, many consumers will eat more chicken.
Key points to remember
- The substitution effect is the decrease in sales of a product that can be attributed to consumers switching to cheaper alternatives when its price increases.
- When the price of a product or service increases but the buyer’s income remains the same, the substitution effect usually occurs.
- The substitution effect is strongest for products that are close substitutes.
- An increase in consumer purchasing power can offset the substitution effect.
Understanding the Substitution Effect
In general, when the price of a product or service increases but the buyer’s income remains the same, the substitution effect kicks in. This is not only manifested in consumer behavior. For example, a manufacturer faced with a price hike for a critical component from a domestic supplier may switch to a cheaper version produced by a foreign competitor.
How, then, can a company get away with raising its price? In addition to the substitution effect, there is the income effect: some of its customers may benefit from an increase in their purchasing power and be ready to buy a more expensive product. A firm’s success in repricing its product is determined in part by how much of the substitution effect is offset by the income effect.
As mentioned, when the price of a product increases, consumers tend to abandon it for a cheaper alternative. It can turn into an endless game of supply and demand. The price of steak is rising, so consumers are replacing pork. This causes the demand for steak to drop, so its price drops and consumers start buying steak again.
It doesn’t just mean consumers are looking for a bargain. Consumers make their choices based on their overall purchasing power and make constant adjustments based on changing prices. They strive to maintain their standard of living despite fluctuating prices.
The substitution effect is triggered when the price of a product increases but the purchasing power of the consumer remains the same.
The substitution effect is strongest for products that are close substitutes. For example, a shopper may choose a synthetic shirt when the pure cotton brand seems too expensive. Eventually, enough buyers might follow suit to have a measurable effect on the sales of the two shirt makers.
Elsewhere, if a golf club raises its fees, some members could quit. However, if there is no comparable alternative to turn to, they may just have to pay to avoid quitting the sport altogether.
As illogical as it may seem, the substitution effect may not occur when the products whose price increases are of inferior quality. In fact, a lower quality product that goes up in price may actually benefit from increased sales.
Products that exhibit this phenomenon are called Giffen products, named after a Victorian economist who first observed it. Sir Robert Giffen pointed out that cheap staples such as potatoes will be bought in larger quantities if their prices rise. He concluded that people on extremely limited budgets are being forced to buy even more potatoes because their rising price puts other, higher quality staples out of their reach.
Substitute Goods may be adequate replacements or inferior Goods. The demand for an inferior good will increase when the overall purchasing power of consumers declines.