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Substitution effect

The change in the quantity of a good a consumer demands as a result only of a change in its price relative to prices of other goods, the consumer’s real income or utility leve! being held constant. Suppose the price of coffee falls; we then expect two kinds of effect on a consumer’s demand for coffee. First, coffee is now cheaper relative to its substitutes tea, orange juice, milk, etc., and we would therefore expect the consumer to drink a little more coffee and a little less of its substitutes. Second, the consumer’s real income has gone up – her given money income can buy more because coffee is cheaper and she is better off as a result. This increased real income will result in increased demands for at !east some goods and coffee (as well as possibly some of its substitutes) may be one of these. The price fall has therefore affected the demand for coffee in two ways, and it is of interest to separate out these two effects. We could imagine that when the coffee price falls we could make an equivalent reduction in the consumer’s money income so as to cancel out completely the effect of the price fall on her real income – she is left just as well off as she was befare. We could then observe the change in her demand which results solely from the change in coffee’s relative price, and this change is called the substitution effect of the price fall. Economic theory predicts that this substitution effect is always unambiguous – more will be demanded following a relative price fall, less following a price rise. On the other hand, the overall change in demand resulting from both the substitution effect and the effect of increased real income (the income effect) is ambiguous: in general, a consumer’s demand for coffee is predicted to increase, decrease or stay the same following a price fall. The reason is that the increase in real income could work with the substitution effect, causing an overall increase in demand, or it could work against the substitution effect, possibly causing an overall decrease in demand. The latter case can only come about if the good is an inferior good, and if it should indeed occur the good concerned is called a Giffen good. The purpose of the analysis of income and substitution effects is to allow economists more than the rather empty statement that after a price change anything can happen. In fact, for all except strongly inferior goods we can be confident that a price fall will increase the quantity demanded of a good, and demand curves can safely be drawn sloping downward from left to right.

Reference: The Penguin Dictionary of Economics, 3rd edt.