What is the Substitution Effect?

Definition: The substitution effect is an economic consequence of a rise in prices where customers are forced to replace a good they currently buy for a cheaper one. It is the result of price increases if the consumer’s budget stays the same.

What Does Substitution Effect Mean?

The substitution effect normally appears in economy’s experiencing a rise in its inflation rate. Since normally wages don’t immediately follow price increases the population tends to adjust their purchase preferences to be able to balance their current budget to fulfill their needs. These substitutions often include the purchase of lower quality products that replace the ones previously bought.

Since the consumer’s preference is not completely fulfilled it can be stated that this effect is seen as a negative experience in the mind of the population. On the other hand, companies are also affected by the substitution effect, normally those that serve the middle class and above, including luxury good’s suppliers, since its customer base is normally the affected one. Finally, companies that manufacture or import lower quality products or had the flexibility to adapt to price rises in order to offer customers budget-conscious options will be favored by this market shift.

Example

Video Retailers Co. is a big video game seller with many stores located across the country. They have been growing the last five years to become one of the largest video game retailers in the U.S. Since interest rates had stay low for a while inflationary pressures have made physical video games prices to increase. These has caused a decline in revenues and the Board is concerned about more potential reductions.

They have identified that a substitution effect is happening in the industry, since customers are now buying games online, since they are cheaper. Video Retailers has to come up with a strategy to compete with these online sellers or they will lose more business each day. The Board decided to hire a digital marketing consultant who developed a strategy to launch an online store with lower prices to adapt to this new economic environment.