Substitution effect of price change (May’11)

Q. Substitution effect of price change (May’11)

The substitution effect of a price change is described below step by step:

(i) The substitution effect is the relative change in the amount of a good consumed
when the price of another good changes. 

(ii) When the price of a good falls, consumers have more real income with the same nominal income and will now buy more of the good. 

(iii) The substitution effect shows how a change in income will affect the quantity of a good purchased. 

(iv) When the price of a good falls, consumers will now substitute this lower-priced good for relatively higher-priced goods.

An example of this would be margarine vs. butter. If the price of butter rises, consumers may substitute margarine (a cheaper good) for butter.