Substitution effect

This article needs additional citations for verification. Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed. Find sources: "Substitution effect" – news · newspapers · books · scholar · JSTOR (April 2025) (Learn how and when to remove this message)

This article's lead section may need to be rewritten. The reason given is: article violates WP:LEAD and WP:VERIFY. Please review the lead guide and help improve the lead of this article if you can. (April 2025) (Learn how and when to remove this message)

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 income effect.^{[not verified in body]}

When a good's price decreases, if hypothetically the same "consumption bundle"^{[clarification needed]} 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 income effect), and the effect of the change on the relative prices 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).^{[not verified in body]}

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.^{[not verified in body]} The idea: if the consumer is given enough money to purchase his old bundle at the new prices, his choice changes will be seen.^{[not verified in body]} If instead, a new budget line is drawn with the slope determined by the new prices, tangent to the "indifference curve"^{[clarification needed]} going through the old bundle, the difference between the new point of tangency and the old bundle is the Hicks substitution effect.^{[not verified in body]} 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.^{[not verified in body]} Varian explains the distinction, and describes the Slutsky effect as the primary one.^{[1][full citation needed]} (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.^{[not verified in body]} 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).

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.^{[according to whom?]} 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.^{[2][full citation needed]} 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.^[3]