The substitution effect is a concept in economics that describes the change in demand for a good as a result of a change in the price of that good relative to other goods. Specifically, it refers to the effect of a change in the price of a good upon the amount of that good demanded by a consumer, in combination with the income effect. The substitution effect measures the change in consumption such that the consumers level of utility does not change. It is called the substitution effect because it reflects the idea that consumers will substitute a cheaper alternative for a more expensive one when the price of the latter increases. The substitution effect is strongest for products that are close substitutes.

The substitution effect is one of two factors that contribute to the law of demand, which states that people buy less of a good as its price goes up. The other factor is the income effect, which concerns the change in demand for a product due to a change in income relative to market prices. The income effect is the change in the consumption of goods based on income, meaning consumers will generally spend more if they experience an increase in income.

Calculating the substitution effect requires isolating the impact of a change in relative prices. The Slutsky equation is a mathematical formula that separates the substitution effect from the income effect. The substitution effect can also be seen in the behavior of companies, such as when they outsource production to take advantage of cheaper labor costs.