How It Works?

To illustrate how relative prices affect demand, consider the morning consumption habit of Duncan Thurly. Duncan buys two glazed donuts and two chocolate brownies from his local bakery, Donuts Dough-Lites, on his way to work every morning. Glazed donuts and chocolate brownies both carry a 50 cent price.

However, what might happen if Duncan enters the Donuts Dough-Lites bakery one morning to discover that the price of glazed donuts has fallen to 25 cents each? In all likelihood, Duncan rethinks his daily mix of pastry purchases. He might be inclined to purchase four glazed donuts and no chocolate brownies.

If Duncan alters his purchases, opting for four tasty glazed donuts, then he has fallen victim to the substitution effect.

Up and Down

• Higher Price: An increase in price causes a decrease in the relative prices of substitute goods. Buyers are inclined to buy more of the other substitute goods and less of this good. The result is a decrease in the quantity demanded.


• Lower Price: A decrease in price causes an increase in the relative prices of substitute goods. Buyers are inclined to buy less of the other substitute goods and more of this good. The result is an increase in the quantity demanded.

Not A Determinant

• Substitution Effect: The substitution effect results from a change in demand price, which affects relative prices given that the prices of other goods remain unchanged. The change in relative prices then causes a change in quantity demanded and a movement along the demand curve. With the substitution effect, the price of this good changes, while other prices are fixed.


• Other Prices Demand Determinant: Other prices are a demand determinant that also affects relative prices. However, in this case other prices change, while the price of this good remains unchanged. The change in other prices causes a change in demand and a shift of the demand curve. With the other prices demand determinant, the price of this good is fixed, while other prices change.

The Income Effect