display | more...
In economics, the substitution effect is the term used to describe the shift of a consumers purchasing choice away from a commodity after its relative price changes whilst maintaining the consumers total utility. This effect is always negative, signifying a move away from a commodity as its price is rising and the consumers try to maintain their standard of living.

When combined with income effect, substitution effect can be used to ascertain the total effect of a price change on the demand for a product.

I have also heard this term used to describe a negative effect on supplies of labor - i.e., the numbers of people who want to do certain jobs - caused by and increase in price of labor.

Basically, under normal circumstances, if the average wage for a particular job increases, then more people want to do it. Fairly obvious - the government increases teachers' salaries, so more people become teachers.

However, the theory, which is supported by empirical evidence, states that sometimes increasing wages can reduce the supply of labour.

To explain this effect, first consider this - free time can be considered "a good", just like a television or a car can be considered to be "a good", since just as a television or a car costs us money, so having lots of free time costs us money: we could be taking on another job in that time. Thus, leisure time can be considered something we "buy" by not working where otherwise we might be able to. Now, if per-hour wages are increasing, once employees can cover their basic needs (like mortgages, food and drink, etc.) they might start to buy more luxurious goods, like a car, a foreign holidays, etc.. But what then? People always want more possessions, sure, but eventually, if their per-hour wage continues to increase, they will use their additional income to "buy" more leisure time, i.e., work less. Thanks to the hike in wages, they can maintain their standard of living, and the value of further leisure time exceeds the value of the further goods they would be able to buy if they worked for the same amount of time at this new higher rate (and thus earned more money).

Log in or register to write something here or to contact authors.