Substitution Effect Definition
Substitution Effect is change in demand for a good as the price of its substitute changes. Say if the price of Commodity A rises, consumers might shift to Commodity B. Substitution effect is seen only in the light of change in relative prices of goods, assuming that the nominal income of the consumer remains the same.
Example of Substitution Effect
Assume someone with an income of $1000 spends their entire income on three commodities – Commodity A, B and C. Now the price of Commodity A, say Broccoli, increases by 10%. As a result of increase in this price, the consumer now finds it hard to afford Broccoli. They then shift to consuming less of Broccoli and more of Commodity C, say cauliflower. This is called Substitution Effect. Opposite would be the case if there was a drop in the price of Broccoli. The consumer would then shift away from using cauliflower and would use more broccoli, which has become relatively cheaper than cauliflower, while price the price of cauliflower in nominal terms has remained the same.
Substitution effect is measured as change in demand of good A as a result of change in price of good B and is closely related to cross price elasticity which shows how demand of one good changes with change in the prices of another. Thus, substitution effect would be positive in case of close substitutes – an increase in the price of Commodity A, lead to an increase in demand for Commodity B, whose price has not increased and which is a close substitute of Commodity A. Vice-versa would be the case when price of Commodity A falls. This holds true for Normal Goods.
For Inferior Goods, this might not be the case. Inferior Goods, as the name suggests, are consumed since people might be on a budget constraint and cannot afford a better quality product. An increase in the price of inferior goods, makes it difficult for people to afford other goods and thus the demand for other goods goes down. Substitution effect in case of inferior goods would be negative.
Substitution Effect versus Income Effect
When the price of Commodity A reduces, the disposal income or real income of the consumer increases. This is because they have more left over to spend. In such a case, the consumer might decide to buy more of Commodity A and Commodity B and not just spend their income on buying more of Commodity A. This new consumption pattern, where the consumer is consuming more of both commodities A and B is a result of both income and substitution effect. Substitution effect would be if the consumer consumed only more of Commodity A, less of Commodity B and stays on the same indifference curve. Income effect would be when the consumer gives up a bit of Commodity A to consume a bit more of Commodity B, compared to what they were before the price drop, and shifts to a higher indifference curve. For a more detailed graphical analysis of this, you may read here.