Substitution effect

In microeconomics, the substitution effect is the change in demand for a good that results from a change in relative prices (i.e. the price ratio). This must be distinguished from the income effect, which describes the change in demand as a result of a change in real income. Both effects occur in parallel. The substitution effect always works in the opposite direction of the price change (price decrease causes demand increase and vice versa).

The substitution effect can be shown graphically as a movement along the indifference curve .

example

Someone feeds on bread and rice. Suddenly the price of bread goes down. With every serving of rice that he now renounces, he can afford more bread than before. If he comes to the conclusion that he should therefore buy less rice and more bread, the substitution effect outweighs the problem.

The income effect, on the other hand, would be the argument that his real budget has increased as a result of the unilateral price reduction and that he could therefore consume more of both goods in the same ratio than before.

See also

• Slutsky decomposition
• Income elasticity
• Complementary goods

Web links

• Income and substitution effect - Article at mikrooekonomie.de
• Substitution effect - definition in the Gabler business dictionary