The substitution effect explains how people change their buying habits when the price of a product changes, while keeping their overall satisfaction level the same.

When a product becomes cheaper relative to others, consumers tend to buy more of that product and less of the more expensive alternatives.

How it works:

• Price drops: The price of Product A falls.
• Relative value: Product A is now cheaper compared to Product B.
• Switching: Consumers choose to buy more of Product A and less of Product B.
• Result: The demand for Product A increases.

Key points to remember:

• It assumes the consumer’s total satisfaction remains the same.
• It focuses only on price changes, not on the consumer’s total wealth.
• For most goods, a lower price leads to a higher quantity demanded.

Example:

If the price of coffee goes down while tea prices stay the same, coffee becomes a better value. Rational consumers will buy more coffee and less tea, which is the substitution effect in action.