substitution effect

Examples of substitution effect in the following topics:

• Applications of Principles on Consumer Choices

  • The income effect and substitution effect combine to create a labor supply curve to represent the consumer trade-off of leisure and work.
  • Central principles to analyzing consumer actions and choices are income effect and the substitution effect, which ultimately generate a labor supply to illustrate the labor-leisure trade-off for consumers.
  • The substitution effect is closely related to that of the income effect, where the price of goods and a consumers income will play a role in the decision-making process.
  • In the substitution effect, a lower purchasing power will generally result in a shift towards more affordable goods (substituting cheaper in place of more expensive goods) while a higher purchasing power often results in substituting more expensive goods for cheaper ones.
  • Explain the labor-leisure tradeoff in terms of income and substitution effects

• Changes in Equilibrium for Shifts in Market Supply and Market Demand

  • This increases the cost of leisure and causes the supply of labor to rise - this is the substitution effect, which states that as the relative price of one good increases, consumption of that good will decrease.
  • However, there is also an income effect - an increased wage means higher income, and since leisure is a normal good, the quantity of leisure demanded will go up.
  • In general, at low wage levels the substitution effect dominates the income effect and higher wages cause an increase in the supply of labor.
  • At high incomes, however, the negative income effect could offset the positive substitution effect and higher wage levels could actually cause labor to decrease.
  • While normally hours of labor supplied will increase with the wage rate, the income effect may produce the opposite effect at high wage levels.

• Impact of Price on Consumer Choices

  • This practice regulates the price companies can set for their products and services, as the income effects and the prospective substitutions (substitution effect) will drive consumer purchase towards purchases that create the most value for themselves.

• How Income is Allocated

  • However, economists view the impact of technological progress to outweigh the effect of globalization, as technology has effectively been substituted for more expensive wage labor.

• Impact of Income on Consumer Choices

  • The wealth effect differs slightly from the income effect.
  • As a result, it is useful to outline the differences in income effects on normal, inferior, complementary and substitute goods:
  • Substitutes: Perfect substitutes are essentially interchangeable goods, where the consumption of one compared to another has no meaningful impact on the consumer's utility derived.
  • Substitutes are goods that a consumer cannot differentiate between in terms of the need being filled and the satisfaction obtained.
  • Break down changes in consumption into the income effect and the wealth effect

• Limits of Fiscal Policy

  • There is controversy regarding whether these two policies are complementary or act as substitutes to each other for achieving macroeconomic goals.
  • The issue of interaction and the policies being complement or substitute to each other arises only when the authorities are independent of each other.
  • When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect.
  • How effective fiscal policy is depends on the multiplier.
  • The greater the multiplier, the more effective the policy.

• Demand Function

  • The behavior of a buyer is influenced by many factors; the price of the good, the prices of related goods (compliments and substitutes), incomes of the buyer, the tastes and preferences of the buyer, the period of time and a variety of other possible variables.
  • Since all the independent variable may change at the same time it is useful to isolate the effects of a change in each of the independent variables.
  • To represent the demand relationship graphically, the effects of a change in PX on the QX are shown.
  • Goods may be related as substitutes (consumers perceive the goods as substitutes) or compliments (consumers use the goods together).
  • If goods are substitutes, (shown in Figure III.A.3) a change in PY (in Panel B) will shift the demand for good X (in Panel A).

• Market Adjustment to Change

  • Income, prices of substitutes, prices of compliments, preferences, number of buyers and expectations are among the many possible variables that influence the demand relationship.
  • Ps is the price of substitutes.
  • In Figure III.A.10 the effects of a shift in demand are shown.
  • The effect on quantity of an increase in both supply and demand will increase the equilibrium quantity while the effect on price is dependent on the magnitude of the shifts and relative structure (slopes) of supply and demand.
  • The effect of an increase in both supply and demand is shown in Figure III.A.12.

• Benefits of Specialization

  • However, specialization can have both positive and negative effects on a nation's economy.
  • The effects of specialization (and trade) include:
  • These effects both contribute to increased overall efficiency for countries.
  • For example, the global demand for rubber has fallen due the the availability of synthetic substitutes.

• Determinants of Price Elasticity of Demand

  • A good's price elasticity of demand is largely determined by the availability of substitute goods.
  • Availability of substitute goods: The more possible substitutes there are for a given good or service, the greater the elasticity.
  • Conversely, if no substitutes are available, demand for a good is more likely to be inelastic.
  • The relative high cost of such goods will cause consumers to pay attention to the purchase and seek substitutes.
  • Food in general would have an extremely low PED because no substitutes exist.