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The substitution effect is the change that would occur if the consumer were required to remain on the original indifference curve; this is the move from A to B. The income effect is the simultaneous move from B to C that occurs because the lower price of one good in fact allows movement to a higher indifference curve.
Only if the two products satisfy the three conditions, will they be classified as close substitutes according to economic theory. The opposite of a substitute good is a complementary good, these are goods that are dependent on another. An example of complementary goods are cereal and milk. An example of substitute goods are tea and coffee.
The substitution effect is the effect that a change in relative prices of substitute goods has on the quantity demanded. It due to a change in relative prices between two or more substitute goods. When the price of a commodity falls and prices of its substitutes remain unchanged, it becomes relatively cheaper in comparison to its substitutes.
If precondition #1 is changed to "The goods in question must be so inferior that the income effect is greater than the substitution effect" then this list defines necessary and sufficient conditions. The last condition is a condition on the buyer rather than the goods itself, and thus the phenomenon is also called a "Giffen behavior".
Which of these effects dominates depends on the magnitude of the elasticity of substitution. When the elasticity of substitution is less than one, the first effect dominates: relative demand for c 2 {\displaystyle c_{2}} falls, but by proportionally less than the rise in its relative price, so that relative expenditure rises.
Constant elasticity of substitution (CES) is a common specification of many production functions and utility functions in neoclassical economics.CES holds that the ability to substitute one input factor with another (for example labour with capital) to maintain the same level of production stays constant over different production levels.
Substitution bias can cause inflation rates to be over-estimated. Data collected for a price index, if from an earlier period, may poorly correspond to the prices and consumer-expenditure-shares going to goods whose prices later changed. To reduce this problem, several steps can be taken by makers of price indices: [1] [2]
> implies two goods are substitutes. Consumers purchase more B when the price of A increases. Consumers purchase more B when the price of A increases. Example: the cross elasticity of demand of butter with respect to margarine is 0.81, so 1% increase in the price of margarine will increase the demand for butter by 0.81%.