The substitution effect is the decrease in sales for a product that can be attributed to consumers switching to cheaper alternatives when its price rises. A product may lose market share for many reasons, but the substitution effect is purely a reflection of frugality. If a brand raises its price, some consumers will select a cheaper alternative. If beef prices rise, many consumers will eat more chicken.
- The substitution effect is the decrease in sales for a product that can be attributed to consumers switching to cheaper alternatives when its price rises.
- When the price of a product or service increases but the buyer's income stays the same, the substitution effect generally kicks in.
- The substitution effect is strongest for products that are close substitutes.
- An increase in consumer spending power can offset the substitution effect.
In general, when the price of a product or service increases but the buyer's income stays the same, the substitution effect kicks in. This is not only evident in consumer behavior. For example, a manufacturer faced with a price hike for an essential component from a domestic supplier may switch to a cheaper version produced by a foreign competitor.
How, then, does any company get away with increasing its price? In addition to the substitution effect, there's the income effect—some of its customers may be enjoying an increase in spending power and be willing to buy a pricier product. A company's success in repricing its product is determined in part by how much of the substitution effect is offset by the income effect.
As noted, when a product price increases consumers tend to drop it for a cheaper alternative. This can turn into an endless game of supply and demand. Steak prices rise, so consumers substitute pork. This leads to a decline in the demand for steak, so its price drops and consumers return to buying steak.
This does not mean only that consumers chase a bargain. Consumers make their choices based on their overall spending power and make constant adjustments based on price changes. They strive to maintain their living standards despite price fluctuations.
The substitution effect kicks in when a product's price increases but the consumer's spending power stays the same.
The substitution effect is strongest for products that are close substitutes. For instance, a shopper might pick a synthetic shirt when the pure cotton brand seems too pricey. Eventually, enough shoppers may follow suit to make a measurable effect on the sales of both shirt makers.
Elsewhere, if a golf club hikes its fees, some members might quit. However, if there is no comparable choice for them to turn to then they may just have to pay up to avoid quitting the sport completely.
As illogical as it seems, the substitution effect may not occur when the products that increase in price are inferior in quality. In fact, an inferior product that rises in price may actually enjoy a sales increase.
Products that display this phenomenon are called Giffen goods, after a Victorian economist who first observed it. Sir Robert Giffen noted that cheap staples such as potatoes will be purchased in greater quantities if their prices rise. He concluded that people on extremely limited budgets are forced to buy even more potatoes because their increasing price places other higher-quality staples altogether out of their reach.
Substitute goods may be adequate replacements or inferior goods. Demand for an inferior good will increase when overall consumer spending power falls.
A substitute, or substitutable good, in economics and consumer theory refers to a product or service that consumers see as essentially the same or similar-enough to another product. Put simply, a substitute is a good that can be used in place of another.
Substitutes play an important part in the marketplace and are considered a benefit for consumers. They provide more choices for consumers, who are then better able to satisfy their needs. Bills of materials often include alternate parts that can replace the standard part if it's destroyed.
- A substitute is a product or service that can be easily replaced with another by consumers.
- In economics, products are often substitutes if the demand for one product increases when the price of the other goes up.
- Substitutes provide choices and alternatives for consumers while creating competition and lower prices in the marketplace.
When consumers make buying decisions, substitutes provide them with alternatives. Substitutes occur when there are at least two products that can be used for the same purpose, such as an iPhone vs. an Android phone. For a product to be a substitute for another, it must share a particular relationship with that good. Those relationships can be close, like one brand of coffee with another, or somewhat further apart, such as coffee and tea.
Giving consumers more choice helps generate competition in the market and lower prices as a result. While that may be good for consumers, it may have the opposite effect on companies' bottom line. Alternative products can cut into companies' profitability, as consumers may end up choosing one more over another or see market share diluted.
When you examine the relationship between the demand schedules of substitute products, if the price of a product goes up the demand for a substitute will tend to increase. This is because people will prefer to lower-cost substitute to the higher cost one. If, for example, the price of coffee increases, the demand for tea may also increase as consumers switch from coffee to tea to maintain their budgets.
Conversely, when a good's price decreases, the demand for its substitute may also decrease. In formal economic language, X and Y are substitutes if demand for X increases when the price of Y increases, or if there is positive cross elasticity of demand.
The availability of substitutes are one of Porter's 5 Forces, the others being competition, new entrants into the industry, the power of suppliers, and the power of customers.
Substitute goods are all around us. As mentioned above, they are generally used for the same purpose or are able to satisfy similar needs for consumers.
Here are just a few examples of substitute goods:
- Currency: a dollar bill for 4 quarters (also known as fungibility)
- Coke vs. Pepsi
- Premium vs. regular gasoline
- Butter and margarine
- Tea and coffee
- Apples and oranges
- Riding a bike versus driving a car
- E-books and regular books
There is one thing to keep in mind when it comes to substitutes: the degree to which a good is a substitute for another can, and often will, differ.
Classifying a product or service as a substitute is not always straightforward. There are different degrees to which products or services can be defined as substitutes. A substitute can be perfect or imperfect depending on whether the substitute completely or partially satisfies the consumer.
A perfect substitute can be used in exactly the same way as the good or service it replaces. This is where the utility of the product or service is pretty much identical. For example, a one-dollar bill is a perfect substitute for another dollar bill. And butter from two different producers are also considered perfect substitutes; the producer may be different, but their purpose and usage are the same.
A bike and a car are far from perfect substitutes, but they are similar enough for people to use them to get from point A to point B. There is also some measurable relationship in the demand schedule.
Although an imperfect substitute may be replaceable, it may have a degree of difference that can be easily perceived by consumers. So some consumers may choose to stick with one product over the other. Consider Coke versus Pepsi. A consumer may choose Coke over Pepsi—perhaps because of taste—even if the price of Coke goes up. If a consumer perceives a difference between soda brands, she may see Pepsi as an imperfect substitute for Coke, even if economists consider them perfect substitutes.
Less perfect substitutes are sometimes classified as gross substitutes or net substitutes by factoring in utility. A gross substitute is one in which demand for X increases when the price of Y increases. Net substitutes are those in which demand for X increases when the price of Y increases and the utility derived from the substitute remains constant.
In cases of perfect competition, perfect substitutes are sometimes conceived as nearly indistinguishable goods being sold by different firms. For example, gasoline from a gas station on one corner may be virtually indistinguishable from gasoline sold by another gas station on the opposite corner. An increase in the price at one station will result in more people choosing the cheaper option.
Monopolistic competition presents an interesting case that present complications with the concept of substitutes. In monopolistic competition, companies are not price-takers, meaning demand is not highly sensitive to price. A common example is a difference between the store brand and name-branded medicine at your local pharmacy. The products themselves are nearly indistinguishable chemically, but they are not perfect substitutes due to the utility consumers may get—or believe they get—from purchasing a brand name over a generic drug believing it to be more reputable or of higher quality.