Question

Which statement describes the substitution effect?

Answer 1

As the price of goods rises, people will substitute other products.

Answer 2

The correct answer is: "As the price of a good rises, people will substitute other products".

The substitution effect (SE) is derived from a product's price variation, together with the income effect (IE).

If the price of a product rises, demand of the product decreases (law of demand) because consumers will switch and demand a substitute good instead, as such goods would allow them to satisfy the same individual need of preference (that is the ultimate objective when making a purchase).

For example, if the price of orange juice rises, some consumers will not be willing to pay the new price and will prefer to consume cheaper peach juice, that satisfies the same need.