Hicksian substitution effect

Hicksian substitution effect
See also
Diminishing marginal utility Law of supply and demand Indifference curve and budget line Competitive equilibrium Normal good Supply curve Price sensitivity Consumption function Demand curve shift

The Hicksian substitution effect is a concept in economics which states that when the price of a good increases, consumers are likely to substitute away from that good and towards another good or service. It is named after John Hicks, who developed the theory in 1937. From a managerial point of view, this concept is important to understand in order to predict consumer behavior. An understanding of the Hicksian substitution effect can help managers make better pricing decisions and better anticipate consumer response to changes in prices. This can be especially useful in industries where there are many substitutes available, such as in the food or beverage industries.

Example of Hicksian substitution effect

• Suppose a consumer has a budget of $100 per month to spend on food, and the price of beef increases by 10%. The Hicksian substitution effect would suggest that the consumer is likely to purchase less beef, and substitute towards other proteins such as chicken, pork, or fish.
• If the price of a cup of coffee increases, a consumer may choose to substitute away from coffee and towards tea, soda, or juice.
• If the price of a car increases, a consumer may choose to substitute away from the car and towards a bicycle, scooter, or public transportation.

When to use Hicksian substitution effect

The Hicksian substitution effect is a concept in economics which states that when the price of a good increases, consumers are likely to substitute away from that good and towards another good or service. It is an important concept to understand for managers when predicting consumer behavior, and it can be useful in making pricing decisions and anticipating consumer response to changes in prices. The Hicksian substitution effect can be used in the following situations:

• For industries with many substitutes: It is especially useful in industries where there are many substitutes available, such as in the food or beverage industries. Understanding the Hicksian substitution effect can help managers anticipate how consumers may respond to changes in prices and decide on the most effective pricing strategy.
• For pricing decisions: By understanding the Hicksian substitution effect, managers can make better pricing decisions to maximize profits. They can determine the price points where consumers are likely to switch to cheaper substitutes, as well as the price points where they are likely to switch to more expensive alternatives.
• For understanding consumer behavior: An understanding of the Hicksian substitution effect can also help managers to better understand consumer behavior. This can be useful in predicting how consumers may respond to changes in prices or other factors that may influence their buying decisions.

Types of Hicksian substitution effect

The Hicksian substitution effect states that when the price of a good increases, consumers are likely to substitute away from that good and towards another good or service. There are two types of Hicksian substitution effect:

• The direct substitution effect occurs when consumers switch from a higher-priced good to a lower-priced good. This type of substitution is motivated by the desire to save money.
• The indirect substitution effect occurs when consumers switch from a higher-priced good to a different good or service, which may not necessarily be less expensive. This type of substitution is motivated by the desire to get a different product or experience.

Advantages of Hicksian substitution effect

The Hicksian substitution effect has many advantages for businesses and consumers. These include:

• Greater Choice: The Hicksian substitution effect allows consumers to choose from a wider variety of goods and services, leading to greater satisfaction and choice.
• Lower Prices: As consumers substitute away from goods with higher prices, the demand for those goods decreases, leading to lower prices overall.
• Greater Efficiency: Since consumers are able to substitute away from goods with higher prices, resources are better allocated to address consumer needs and preferences.
• Increased Competition: As consumers substitute away from certain goods and services, competition increases among producers, leading to more innovation and better products.
• Increased Profits: When consumers substitute away from certain goods, businesses are able to focus on selling more of the goods that people actually want, leading to increased profits.

Limitations of Hicksian substitution effect

The Hicksian substitution effect has several limitations that should be taken into consideration when making managerial decisions. These limitations include:

• The effect is limited to goods and services that are close substitutes. If the substitutes are not close enough, the effect will be diminished.
• The effect is based on the assumption that consumers have perfect knowledge of the market and different prices, which may not always be the case.
• The effect assumes that consumers will continue to buy the same quantity of the good even if the price changes, which may not always be the case.
• The effect assumes that consumers only react to price changes and not other factors such as quality or availability.
• The effect assumes that all consumers are the same and react in the same way, which may not always be true.

Other approaches related to Hicksian substitution effect

The Hicksian substitution effect is a concept in economics which states that when the price of a good increases, consumers are likely to substitute away from that good and towards another good or service. Other approaches related to this effect include:

• Giffen Good: This refers to a commodity which is purchased more when its price increases. This is contrary to the expected behaviour of the consumer in the face of a price increase and was first noted by British economist Sir Robert Giffen.
• Substitution Bias: This refers to the tendency of consumers to substitute away from two goods when the price of one of them increases. This results in a decrease in demand for both goods.
• Income Effect: This effect states that when the price of a good increases, consumers substitute away from that good as their purchasing power decreases.
• Engel Curve: This curve shows how the demand for a good changes as income changes. It suggests that as income increases, demand for a good will also increase.

In summary, the Hicksian substitution effect is an important concept in economics which helps to explain consumer behaviour and how it changes in response to price changes. Other approaches related to the effect include Giffen Good, Substitution Bias, Income Effect, and Engel Curve.

Suggested literature

• Hines Jr, J. R. (2013). Income and substitution effects of estate taxation. American Economic Review, 103(3), 484-488.
• Gimenez-Nadal, J. I., & Molina, J. A. (2017). The Substitution Effect and the Profit Function in Consumption: expressions from the Marshallian, Hicksian, and Frischian demand functions.