The substitution effect is a change in consumption patterns due to changes in the relative prices of goods and services. Consumers replace more expensive products with cheaper ones. So, if the price of a product rises, consumers switch and increase the demand for substitute products.
The difference between the income effect and the substitution effect
Changes in prices have two different consequences:
- Income effect
- Substitution effect
The combination of the two is known as the price effect. The income effect describes changes in the price of goods on consumer purchasing power. It associates the change in quantity demanded to changes in the price of a product.
Meanwhile, the substitution effect explains how relative price changes affect consumer choices. When choosing a product, consumers will consider its price as well as the price of alternative products. The concept comes from the cross-price elasticity of demand.
For example, when the price of Pepsi goes up, your purchasing power of money goes down. The income effect states that you will reduce your Pepsi consumption. Are you going to switch to Coca-Cola?
The answer, not necessarily. The substitution effect answers this question. For example, when the price of Coca-Cola is constant, you might switch. However, if at the same time, the price also rises and is higher than the increase in Pepsi. Of course, you should not turn because the cost of Pepsi is lower than before, relative to the price of Coca-Cola.
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The substitution effect is always negative (or zero). Meanwhile, the income effect can be positive and negative, depending on whether the product is inferior or normal.
Implications for competition
Substitution goods play an essential role in the market. It is considered beneficial for consumers because it provides more choices for them. That way, they can choose products that are suitable and able to meet their needs.
Meanwhile, for producers, the presence of substitution is a threat. Mistakes in pricing can cause consumers to switch to substitute products, weakening sales, and reduce company profits.
The threat becomes serious if the alternative product is perfect substitution or, at least close substitution. A small increase in the product price will have a sharp decline in its demand as more consumers switch to the substitutes.
For this reason, many companies try to differentiate their products. Differentiation increases the switching costs that consumers bear. It also allows consumers to be more loyal.
The company can combine branding, advertising, or other elements of the marketing mix. That way, companies reduce the pressure from the threat of substitution, allowing them to operate more profitably.
Effects on several types of goods
The substitution effect always acts to increase the consumption of an item when its price falls. Conversely, in the income effect, when prices drop, the demand for goods can increase or decrease, depending on the type of products.
We will discuss the effects of income and substitution on the following three categories of goods:
- Normal goods
- Inferior goods
- Giffen goods
Normal goods are types of goods whose demand will decrease when consumer income decreases, and demand will rise when consumer income increases.
Normal goods have a positive income effect. When the price of normal goods falls, it increases consumer’s real income and purchasing power, increasing demand for the goods.
Meanwhile, the substitution effect also works on the item. Declining prices, making them cheaper alternatives, encourage consumers to switch from alternative products to these products, and ask for more.
The opposite effect also applies when normal goods prices rise. The income effect works to reduce demand due to decreased purchasing power. Likewise, higher prices cause consumers to switch to alternative products.
Inferior goods are goods that have a negative income elasticity of demand. When income rises, demand falls, and vice versa, when income decreases, demand increases.
The income effect works in the opposite direction to the substitution effect for inferior products. Inferior goods have a negative income effect. In a sense, when the price falls, the real income of the consumer rises and does not want the product. As a result, the quantity demanded falls.
The substitution effect works to increase the demand for inferior goods when prices fall. And, the effect is significant enough to exceed the income effect.
As a result, the effect of falling prices on the quantity demanded of an item is still positive. However, the change in quantity demanded is not too significant because the income effect partially offsets the substitution effect of falling prices.
Giffen goods are exceptional cases of inferior products. The income effect of falling goods prices is so strong that it exceeds the substitution effect. As a result, when prices drop, the quantity demanded actually falls.
Please note that not all inferior goods are in the Giffen category. However, Giffen goods must be inferior goods.