Substitution Effects Short Answers

In this short video we explore two questions relating to substitution effects in a market.

The two questions are:

1. What is meant by the substitution effect in a market for two or more products?
2. Goods X and Y are substitutes. Explain how a change in the cost of producing good X might affect the demand curve and the supply curve of good Y?

The substitution effect:

• The substitution effect describes the change in demand for a product when its relative price changes.
• For example, a rise in the price of music downloads on the Apple iTunes store might cause some consumers to substitute their spending to streaming services such as Spotify
• The closer two products are as substitutes and the lower the cost / inconvenience of switching, then the stronger will be the substitution effect.

Goods X and Y are substitutes. Explain how a change in the cost of producing good X might affect the demand curve and the supply curve of good Y?

• A change in the cost of producing good X will cause a shift in the supply of X
• For example, an increase in costs for energy suppliers might lead to a rise in the market price of electricity supplied to households.
• Some people may decide that this price hike is a good reason to spend money on solar panels (a substitute) to start generating their own renewable energy.
• An inward shift in the supply of Good X will cause a rise in the price of Good X
• This will cause an outward shift in the demand curve for the substitute good Y
• This will lead to an expansion along the supply curve for good Y – the market will reach a new equilibrium with a higher price and quantity traded.