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PERFECT COMPETITION, PROFIT MAXIMIZATION: A perfectly competitive firm is presumed to produce the quantity of output that maximizes economic profit--the difference between total revenue and total cost. This production decision can be analyzed directly with economic profit, by identifying the greatest difference between total revenue and total cost, or by the equality between marginal revenue and marginal cost.

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SUBSTITUTION EFFECT:

The change in quantity demanded that results because a change in the demand price of a good causes a change in the relative prices, which induces buyers to substitute the purchase of one good for another. This is one of two reasons, or effects, underlying the law of demand and the negative slope of the market demand curve. The other is the income effect.
The substitution effect offers part of an explanation for the law of demand and the negative slope of the demand curve. It rests on the observation that a change in price changes the relative price of substitute goods. If the price rises, then substitute goods become relatively less expensive to buy. If the price falls, then substitute goods become relatively more expensive to buy.

How It Works?

Buyers decide how much of different goods to purchase based, in part, on relative prices. As the price of one good changes, it changes relative to the prices of others goods, given that the other prices do not change. This induces buyers to alter the mix of goods purchased.

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

Consider the substitution effect from both sides of a price change.
  • 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

The substitution effect is triggered by a change in demand price, given that the prices of other goods remain constant. This effect needs to be distinguished from a seemingly similar notion, the other prices demand determinant for a substitute good.
  • 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

The substitution effect is one of two effects underlying the law of demand and negative slope of the demand curve. The other is the income effect, which results because a change in price changes the purchasing power of income. While both effects are important, for most goods, the substitution effects tends to play the biggest role in a change in quantity demanded.

<= SUBSTITUTE-IN-PRODUCTIONSUPPLY =>


Recommended Citation:

SUBSTITUTION EFFECT, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2016. [Accessed: July 1, 2016].


Check Out These Related Terms...

     | income effect | law of demand | demand schedule | demand curve | demand space | demand determinants | consumer surplus | change in demand | change in quantity demanded |


Or For A Little Background...

     | demand | demand price | quantity demanded | market | quantity | price | unlimited wants and needs | economic analysis | exchange | scarcity | good | service | cause and effect | satisfaction |


And For Further Study...

     | market demand | competition | consumer sovereignty | competitive market | efficiency | exchange | net-export effect |


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