The substitution effect refers to the change in consumption resulting from:
A A change in the relative prices of goods.
B A change in income.
C A change in the price of a good.
D A change in the quantity of a good consumed.
The correct answer and explanation is:
The correct answer is A: A change in the relative prices of goods.
The substitution effect is a fundamental concept in economics that explains how consumers adjust their purchasing behavior when the prices of goods change. Specifically, when the price of a good rises, consumers tend to buy less of that good and substitute it with another good that has become relatively cheaper. This shift occurs because consumers seek to maximize their utility or satisfaction, and they adjust their choices in response to price changes.
For example, consider the case of two goods, apples and oranges. If the price of apples increases, apples become more expensive compared to oranges. As a result, consumers may buy fewer apples and substitute them with more oranges, assuming that oranges offer similar utility at a lower price. This behavior highlights the substitution effect.
It is important to distinguish the substitution effect from the income effect, which also occurs when prices change. The income effect refers to the change in a consumer’s purchasing power when the price of a good changes. For instance, if the price of apples falls, consumers may feel richer, increasing their overall consumption of goods, including apples. However, the substitution effect specifically focuses on the relative price change between two goods, leading to a shift in consumption patterns without necessarily altering the consumer’s overall income or wealth.
In summary, the substitution effect is a reaction to changes in the relative prices of goods. It explains how consumers will substitute one good for another when the price of one good rises or falls, making it a critical component in understanding consumer behavior and market demand.