Substitution effect

The substitution effect is the is the effect of the rise in price of one good that causes a rise in demand for another good. Goods are substitutes if their cross price elasticity of demand is positive.

If goods are very close substitutes (if the cross price elasticity of demand is high) then the producers of the goods are considered to be in the same industry. There is no definite numerical value of cross price elasticity at which this happens.

However, the substitution effect does not only apply to goods within an industry: it may also apply to very different goods: for example a rise in the price of travel may raise demand for telecommunications services.

Demand depends on a number of other factors including the income effect and the prices of complementary goods. The substitution effect is closely linked to the income effect for particular goods, specially where the effect of changes in prices and incomes is to change consumers choice of a luxury good over a cheaper substitute and vice-versa.

Copyright © 2005-2016