Substitution Effect

A rational customer will swap a relatively cheaper good for a more expensive one when the relative prices of different goods vary. The substitution effect is the name given to this outcome of shifting relative prices of products. According to this effect, the consumer will typically purchase more of a good whose price has decreased and less of a good whose price has kept the same or grown because he will reallocate his spending in favor of the relatively cheaper good and replace the more expensive one.

When a comparably cheaper good or service is substituted for a more expensive one while holding the price of the other good, real income, and consumer preferences constant, the quantity required changes or fluctuates as a result of the price shift of the commodity or good.

The consumer's purchase is rearranged in response to a change in the relative pricing of goods, while his level of income remains constant, to ensure that his level of satisfaction will remain the same. This is how the pure substitution impact is calculated. We therefore select a consumer model with a fixed income level and two goods—an apple (A) and an orange (B)—in which the price of the apple declines but the price of the orange stays the same or constant in order to measure the pure substitution impact. We should take the change in his real income into account when measuring the pure substitution effect in this scenario.

The law of demand states that as apple prices decline, the consumer's real income increases because he can now purchase more apple units with the money he has been given. The consumer's money income must be changed appropriately to maintain his real income (purchasing power in terms of apples) at the original level in order to counteract the effects of an increase in income. Thus, we must remove his surplus income, leaving him neither better nor worse off than before. The compensatory variance in income is what we refer to as. Simply put, compensating variation in income refers to a change in the consumer's income that is sufficient to make up for a change in the relative prices of items, leaving the consumer's situation unaffected.

Hicks has described that the substitution effect independent of the income effect through compensating variation in income. “The substitution effect is the increase in the quantity bought as the price of the commodity falls, after adjusting income so as to keep the real purchasing power of the consumer the same as before. This adjustment in income is called compensating variations and is shown graphically by a parallel shift of the new budget line until it becomes tangent to the initial indifference curve.”

The substitution effect thus evaluates the impact of a change in the relative price of a good while holding real income constant on the basis of compensatory variation approaches. The consumer's rise in real income as a result of, say, good X's lower price is so minimal that he is neither better off nor worse off than before.

This adjustment in the income line is implied by the compensating variation in income in the indifference analysis, which maintains the consumer on the original indifference curve despite a change in the relative prices of two items X and Y. So, notwithstanding the compensatory variation in income, the substitution effect can be described as the change in the mix of items purchased as a result of a change in their relative pricing. This means that if the consumer increases his purchase of commodity X when its price decreases, he can reallocate his income expenditure in order to generate a pure substitution effect, notwithstanding the offsetting variance in income.

Reference

Koutosoyianis, A (1979), Modern Microeconomics, London Macmillan