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{{Short description|Microeconomic effect due to a price change}}
{{Use American English|date = March 2019}}
{{Use mdy dates|date = March 2019}}

In [[economics]] and particularly in [[consumer choice theory]], the '''substitution effect''' is one component of the effect of a change in the price of a good upon the amount of that good demanded by a consumer, the other being the [[Consumer theory#Income effect|income effect]].{{citation needed lead|date=April 2025}}

When a good's price decreases, if hypothetically the same "consumption bundle"{{what|date=April 2025}} were to be retained, income would be freed up which could be spent on a combination of more of each of the goods; thus, the new total consumption bundle chosen, compared to the old one, reflects both the effect on freed-up income (the ''[[Consumer theory#Income effect|income effect]]''), and the effect of the change on the [[relative price]]s of the two goods (the ''substitution effect'', one unit of one good now being traded for a different quantity of the other good, as the ratio of their prices has changed).{{citation needed lead|date=April 2025}}

If income is altered in response to the price change such that a new budget line is drawn passing through the old consumption bundle, but with the slope determined by the new prices and the consumer's optimal choice is on this budget line, the resulting change in consumption is called the '''Slutsky substitution effect'''.{{citation needed lead|date=April 2025}} The idea: if the consumer is given enough money to purchase his old bundle at the new prices, his choice changes will be seen.{{citation needed lead|date=April 2025}} If instead, a new budget line is drawn with the slope determined by the new prices, tangent to the "indifference curve"{{what|date=April 2025}} going through the old bundle, the difference between the new point of tangency and the old bundle is the '''Hicks substitution effect'''.{{citation needed lead|date=April 2025}} The idea: the consumer is given just enough income to achieve his old utility at the new prices, and his choice change is now likewise seen.{{citation needed lead|date=April 2025}} [[Hal Varian|Varian]] explains the distinction, and describes the Slutsky effect as the primary one.<ref>Varian, H. Intermediate Microeconomics, 9th Edition. New York: W.W. Norton, 2014.{{page needed|date=April 2025}}</ref>{{full|date=April 2025}} (The Hicks substitution effect is illustrated in the next section.)

The same concepts also apply if the price of one good goes up instead of down, with the substitution effect reflecting the change in relative prices and the income effect reflecting the fact the income has been soaked up into additional spending on the retained units of the now-pricier good.{{citation needed lead|date=April 2025}} For example, consider [[coffee]] and [[tea]]: if the price of coffee increases, consumers of hot drinks may decide to start drinking tea instead, causing the demand for tea to increase (and vice versa).<!--Despite the culinary thrust, readers do not need to be spoon fed: are  Likewise, if the price of coffee was to decrease, tea-drinkers may decide to shift their drinking habits and substitute coffee for their daily drinking habits, causing the demand for tea to decrease.-->

Economists had long understood that changes in price could lead to two main responses by consumers, with initial work on this subject had been done by [[Vilfredo Pareto]] in the 1890s; but it wasn't until [[Eugen Slutsky]]’s 1915 article that rigor was brought to the subject.{{says who|date=April 2025}} Because Slutsky’s original paper was published during World War I in Italian, economists in the Anglo-American world did not become aware of Slutsky’s contributions until the 1930s.<ref>Chipman, John, and Lenfant, Jean-Sébastien. 2002. “Slutsky’s 1915 Article: How It Came to Be Found and Interpreted.” History of Political Economy 34 (3).{{page needed|date=April 2025}}</ref>{{full|date=April 2025}} The English world was fully introduced to Slutsky's ideas in 1934 when "A Reconsideration of the Theory of Value" was published by [[John Hicks]] and [[R.G.D. Allen]], this paper built upon work by Pareto and came to conclusions Slutsky had realized two decades prior.<ref>{{Cite journal|doi = 10.1007/s40797-016-0034-y|title = Slutsky Revisited: A New Decomposition of the Price Effect|year = 2016|last1 = Sasakura|first1 = Kazuyuki|journal = Italian Economic Journal|volume = 2|issue = 2|pages = 253–280|s2cid = 156439853|doi-access = free}}</ref>

==Graphical analysis==
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[[Image:Hicks Substitution effect.svg|Example of a substitution effect]]

Suppose the initial situation is given by the graph (with good Y plotted horizontally) with the indicated (and never-changing) [[indifference curve]]s shown and with [[budget constraint]] BC1 and with the consumer choosing point A because it puts him on the highest possible indifference curve consistent with BC1. The position and slope of the budget constraint are based on the consumer's income and on the prices of the two goods X and Y. If the price of Y falls, the budget constraint pivots to BC2, with a greater intercept of good Y because if all income were spent on Y more of it could be purchased at the now-lower price. The overall effect of the price change is that the consumer now chooses the consumption bundle at point C.

But the move from A to C can be decomposed into two parts. The '''substitution effect''' is the change that would occur if the consumer were required to remain on the original indifference curve; this is the move from A to B. The income effect is the simultaneous move from B to C that occurs because the lower price of one good in fact allows movement to a higher indifference curve. (In this graph Y is an inferior good since C is to the left of B so Y<sub>2</sub> < Y<sub>s</sub>.)

== Elasticity of substitution ==
The concept of the elasticity of substitution was developed by two different economists, each with their own focus. [[John Hicks]] defined elasticity of substitution—also known as the direct elasticity of substitution—as the percent change in the relative number of factors of production used given a particular percent change in relative prices or marginal products. [[Joan Robinson]] defined elasticity of substitution as the change in the ratio of the number of factors used divided by the change in the ratio of each factor's prices. These two definitions function in the same way when limited to two factors of production.<ref>Helm D.R. (2008) Elasticity of Substitution. In: Palgrave Macmillan (eds) The New Palgrave Dictionary of Economics. Palgrave Macmillan, London. {{doi|10.1057/978-1-349-95121-5_468-2}}{{page needed|date=April 2025}}</ref>{{full|date=April 2025}}

== See also ==
* [[Slutsky equation]]
* [[Consumer theory#Income effect]]
* [[Income–consumption curve]]

==References==
{{Reflist}}

[[Category:Consumer theory]]