What is a Substitute?

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Definition:

A substitute is a good or service that a customer views as being very similar to another good or service — so much so that one can replace the other.

🤔 Understanding substitutes

Substitutes are products that provide the same benefit to a consumer. While there may be differences in quality, labeling, and price, the goods or services are basically interchangeable. Some products are very similar — called close substitutes — and they can directly replace each other. In the extreme, there are perfect substitutes, which are identical products with different branding. Products can still be substitutes, even with very different compositions, because they fulfill the same basic need. In microeconomics, goods and services are considered substitutes if a reduction in the price of one causes a decrease in demand for the other.

Example

Many people who drink cola have a preference between Pepsi and Coke. For some people, the two brands serve the same purpose and are easily interchangeable. Other people cringe when they order one and the server asks if the other is okay.

The real test comes if you offer a person the two brands at different prices. If it only takes a few cents difference to get them to switch, then they consider the products to be close substitutes. If they would rather go thirsty than drink the brand they dislike, then the brands are not substitutes for them at all.

Takeaway

Substitutes are like siblings…

Chances are, you have a lot in common with your brothers and sisters. You probably share facial features and mannerisms. You might even have similar tastes in music and movies. In the extreme case, you might have an identical twin (a perfect substitute). If you do, you might be able to switch places without anyone noticing.

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What is the difference between perfect vs. less perfect substitutes?

Many goods and services can stand in for one another. You can substitute margarine for butter without many people noticing. You can also replace a car with a bus ticket for transportation, although you will probably recognize the difference. The point is, there are degrees of substitutability.

Some things are identical products, and those are called perfect substitutes. Other things work in a pinch, but are very different from each other. For example, juice and milk both satisfy thirst. So, they may be substitutes in that regard. But they aren’t interchangeable in your breakfast cereal.

In cases that goods are perfect substitutes, economic theory suggests that there would be perfect competition. If a seller tried to charge more than a competitor, customers would immediately buy from someone else providing the same item at a lower price.

Perfect substitution leads to perfect competition, which forces everyone to charge the same amount.

Examples of perfect substitutes are usually limited to things that have not been transformed into higher-value products. For example, an Alaska king salmon is the same product regardless of where you buy it. But an entree made from king salmon could be very different when offered at different restaurants.

In other cases, two products can be nearly the same, but not quite. These are called near-perfect, close, strong, or near substitutes. Even if the only difference is the label on the package, people might be willing to pay a little more for the brand they like.

This situation is called monopolistic competition — In which several companies offer slightly different products at slightly different prices. The more similar the products are, the less pricing power a company has.

An example of a close substitute might be gasoline sold at different franchises. Although both stations sell a very similar product, one might include additives that increase what you are willing to pay for it.

Even further apart, products might be weak substitutes. In those situations, the items might have some ability to replace one another. But the goods are different enough that people don’t view them as the same. You might not even think to consider weak substitutes as being related until the price of one changes dramatically.

If the cost of peanut butter shoots through the roof, you might expect to see more almond butter sales. Those are natural substitutes. But you might also see an increase in macaroni consumption. That weak substitution might escape your intuition until it happens. (Opting for a lunch of mac and cheese instead of PB&J.)

What is the effect of a price change on substitute goods?

The more similar two products are, the stronger they are as substitutes. Therefore, stronger substitutes will influence each other’s prices more than weak substitutes will.

Economists measure how strong a substitution relationship is by looking at the cross-price elasticity, also called the cross elasticity of demand.

Cross-price elasticity = % change in sales of good A / % change in price of good B

Whenever Good A and Good B have a positive cross-price elasticity of demand, they are considered substitutes. A higher number indicates a stronger substitutability between the products. Numbers close to zero are not substitutes at all.

Consider this example. Let’s say that a fruit stand offers apples for $0.25 and oranges for $0.50. During a typical month, the owner sells 1,000 apples and 1,000 oranges. Then, their vendor increases the cost of apples. In response, the fruit stand raises the price of an apple to $0.30.

Seeing a higher price, customers opt to buy 100 more oranges and 100 fewer apples. With this information, you can determine the cross-price elasticity of these two fruits.

Cross-price elasticity = % change in sales of oranges / % change in price of apples

% change in sales of oranges = 1,100 / 1,000 – 1 = 0.1 = 10%

% change in price of apples = 0.30 / 0.25 – 1 = 0.2 = 20%

Cross-price elasticity = 10% / 20% = 0.5

The 20% price increase in apples caused a 10% increase in the volume of oranges sold. Because these two measures moved in the same direction, they are substitute goods.

The positive cross elasticity of demand describes the strength of substitution, in this case, 0.5. You could compare that number to the cross-price elasticity of other products to see which substation effects are most potent.

In the case of perfect substitution, a tiny change in price would shift all the purchases to the perfect substitute. Seeing as a small change would approach a zero percent change in the denominator of the equation, the cross-price elasticity of perfect substitutes would approach infinity.

If there were no changes in the sales of good A, the numerator would be zero. Therefore, the cross-price elasticity would be zero. Hence, a result of zero indicates that there is no relationship between the products.

What is the difference between substitute goods vs. complementary goods?

While some items can replace each other, other items just go together. Take peanut butter and jelly, for example. If all of a sudden, the world ran out of peanut butter, you can assume that people would buy less jelly. Sure, people would still buy some jelly for toast and other reasons, but you would expect the volume of sales to fall a little.

That’s because peanut butter and jelly are complementary goods. While peanut butter and almond butter are substitutes, peanut butter and jelly are complements.

Many items complement each other. Consider popcorn and soda at the movies. Or meat and potatoes for dinner. Even pepperoni and cheese sales are probably related. A price change in one likely impacts the sales of the other to some degree.

Just like with substitutes, we can quantify the strength of how complementary two goods are by looking at the cross-price elasticity (how much a price change in one impacts the demand for the other).

However, complementary goods have a negative cross-price elasticity, while substitutes have a positive value. The more negative the number, the more interdependent they are.

How do substitute goods affect demand?

The law of demand states that there is an inverse relationship between a product’s price and its volume of sales. However, this relationship assumes that everything else that influences a person’s willingness to purchase the product is held constant.

In other words, the demand for a product can be drawn in two dimensions, price and quantity, as long as you ignore every other aspect that goes into a person’s decision to make a purchase.

If any of those other factors changes, the demand for everything gets shifted. For example, if a person gets a pay raise, their willingness to buy things will adjust to a new budget. Likewise, a change in the price of one item can alter a person’s decision to purchase others.

These outside influences are called determinants of demand. If any determinant changes, a new demand curve gets established.

That is what economists mean when they say that something affects the demand for a product. An increase in income increases the demand for almost everything (except inferior goods).

Likewise, an increase in the price of a substitute increases the demand for a product. The more similar the alternatives are, the stronger the substitution effect will be. So the demand for close substitutes increases more than a similar price increase in weak substitutes.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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