Given a constant money income, a change in the relative prices of two goods may force a consumer to rearrange his purchases. He may re-arrange his purchased of the tow goods in such a way that his satisfaction remains the same. This is known as the substitution effect. This substitution effect refers to the change in the consumption (or demand) of two commodities as a result of their relative change in prices. The total utility remaining the same we assume here that:
- Money income remains the same.
- The relative price levels have change, making one commodity cheaper than the other; and
- The cheapness of one commodity and expensiveness of the other cancel each other and therefore, the consumer is left on the same indifference curve.
The consumer will obviously buy more of the commodity, which is now comparatively cheaper; he will substitute the relatively cheaper commodity. In Fig, The two axes represent two goods as usual. LM is the budget line and A indicates the equilibrium position. The ideal combination of the two commodities is OX, of commodities A and Y. Suppose the prices have changed, and Y have become costlier and X cheaper. The cheapness of the one and the costliness of the other have neutralized or compensated each other so that the consume remains on the same indifference curve. The consumer finds a new equilibrium point B on L1M1 and the total combination of the goods now is Ox2+OY2. It will be noticed that the consumer has now more of X, which is cheaper and less of Y, which are dearer (x1x2, substitutes Y1Y2). The move along the same indifference curve from A to B from X1 to X2 represents the substitution effect i.e., the substitutions of the dearer commodity by the cheaper commodity.
What will be the substitution effect when the price of X alone falls? Since X has become cheaper in relation to other commodities, the consumer would prefer X to others. This substitution will take place even if we assume that the increase in real income is not available to him. The increase in the purchase of a commodity due to a fall in the relative price after subtracting the a commodity due to a fall in the relative price after subtraction effect for a fall in price. The substitution effect is always be followed by a larger demand for the product. In the Figure, The equilibrium point is to the right of A. This shows that the consumer substitutes the dearer commodity with the cheap commodity. It may be noted that:
- The income effect on demand implies a shift from one indifference curve to another (from lower to higher indifference curves in the case of rise in income and from higher to lower indifference curves in the case of decline in incomes); and
- The substitution effect implies a movement from one point to another on the same indifference curve.