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The Substitution Effect in Macroeconomics: Definition & Example

The Substitution Effect in Macroeconomics: Definition & Example
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  • 0:02 Substitution Effect Definition
  • 1:18 Examples
  • 2:48 Lesson Summary
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Lesson Transcript
Instructor: Aaron Hill

Aaron has worked in the financial industry for 14 years and has Accounting & Economics degree and masters in Business Administration. He is an accredited wealth manager.

Learn what the substitution effect is and how it may affect your life every time you go to the grocery store. See some everyday examples of the substitution effect at work.

Substitution Effect Definition

Have you ever bought or tried a different product or brand because the price of what you normally buy was getting too high? Maybe it was a certain brand of deodorant, razors, or possibly your favorite shampoo. You may also have switched cable television or internet service providers or even your car insurance provider. Every time you do this, the substitution effect is at work.

The substitution effect is based on the idea that as prices rise, consumers will replace more expensive items with cheaper substitutions or alternatives, assuming income remains the same. As prices increase for a good, we start to think of other products or choices that can satisfy us at a relatively lower price. Given our budget has stayed the same, we must continually find ways to meet our needs as prices increase around us.

The goods we switch over to after a price increase are called substitute goods. The demand for substitute goods increases as the competing good's price increases. For example, when the price of your favorite shampoo goes up a dollar, you decide to try a cheaper brand. Your demand and many other people's demand for the cheaper shampoo has now increased as a result of the price increase of your favorite shampoo.

Examples

Let's take a look at some examples of situations where the substitution effect may come in to play.

Many people switch their diet of meats and proteins according to the current prices they are paying at the grocery store. A very common example of the substitution effect at work is when the price of chicken or red meat rises suddenly. For instance, when the price of steak and other red meat increases over the short-term, many people eat more chicken. When chicken becomes more expensive, people will substitute more red meat options into their daily needs.

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