What is the substitution effect in economics?
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The substitution effect is when there is a change in quantity demanded due to the change in the price of one good relative to another good. Consumers take the good whose price stayed low and substitute it for the good whose price rose. Let us look at an example.
Let us say that a person goes to the store every morning and buys 2 donuts and two bagels for breakfast. Let's say they cost the same. But now what happens if the price of the donuts goes up, say from $.75 to $1, while the price of bagels stays the same? It may be that the person will start to buy 3 bagels and only one donut. This is an example of the substitution effect. The quantity demanded of donuts has gone down because its price rose relative to bagels and the customer bought a third bagel as a substitute for the second donut.
Substitution goods are those goods which can be used in exchange of each other without sacrificing the satisfaction level. On the other hand the Substitution effect is the effect whereby one good is being effected inversly by another good.
The idea that as prices rise (or incomes decrease) consumers will replace more expensive items with less costly alternatives. Conversely, as the wealth of individuals increases, the opposite tends to be true, as lower-priced or inferior commodities are eschewed for more expensive, higher-quality goods and services - this is known as the income effect.
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