The Substitution Effect - 32

The substitution effect applies when supply decreases as well.

In the diagram to your left, the cost of locally made cars has increased from $18,000 to $20,000. This could have been caused by an increase in government taxes, or an increase in the cost of production (such as increases in wages paid to your production line staff). In any case, the decrease in supply (shown as the movement from E to E1 has caused a contraction in demand for domestically made cars (cars made in Australia). Now only ten cars are sold per week from the car yard we are studying.