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What are Substitute Goods?
Definition: In economics, Substitute goods are products that satisfy the same need or purpose. A substitute good can be either a perfect substitute or an imperfect substitute. Perfect substitutes are exactly alike and can be used interchangeably. Imperfect substitutes are not exactly alike, but can still be used to satisfy the same need or purpose, for example, different grades of gasoline.
Close substitutes satisfy the same needs or purposes. For example, butter and margarine are substitute products.
Substitute goods are products that can be used in place of one another. They have the same purpose but may differ in form or function.
For Example, Let’s say you’re in the market for a new vehicle. You’ve narrowed your choices down to two models: a Ford SUV and a Chevy SUV.
Both SUVs serve the same purpose: they seat five people, have four doors, and can transport you and your family from Point A to Point B. They also have similar features, such as air conditioning, power windows, and cruise control.
The main difference between the two vehicles is that they are made by different manufacturers. Ford and Chevy are substitute products because they serve the same purpose but differ in form or function.
Let’s delve a bit deeper into the world of economics and explore the concept of substitute products-
A customer buys a pair of Nike shoes instead of Adidas shoes because they are cheaper. In this case, the customer is substituting one product for another because it is cheaper. However, there can also be cases where a customer buys a more expensive product because it is of better quality.
An example of this would be a customer buying a pair of designer jeans instead of a pair of cheap jeans from Walmart. The customer is willing to pay more for the designer jeans because they are better quality.
Substitute goods are important in economic analysis because they help determine the demand for a good. The Substitute goods a consumer is willing and able to purchase affect the demand for the good in question. If the Substitute goods are close substitutes, then an increase in the price of the Substitute good will lead to a decrease in the demand for the good in question.
Conversely, if the Substitute goods are not close substitutes, then an increase in the price of the Substitute good will not have a significant effect on the demand for the good in question. Substitute goods are also important in studying monopolies and oligopolies because they can exert downward pressure on prices charged by firms in these market structures.
You may also hear the term “complementary goods” used to describe Substitute Goods. Complementary goods are products that are often used together. For example, a baseball glove and a baseball are complementary goods because you need both items to play the game
Cross Elasticity of Demand
Cross elasticity of demand means how much quantity of one product will be demanded if the price changes as compared to its substitute.
Positive cross-elasticity of demand will mean an increase in the price of one product which will lead to an increase in demand for the other product. This is because the two products are substitutes for each other.
The demand curve for a substitute product is shifted to the right when the price of the other product increases.
Here is an explanation of the cross elasticity of demand.
Above is an image from Wikipedia, which explains the cross elasticity of demand. We can see that as the price of Coca-Cola rises from P1 to P2, this will result in people reducing their consumption of Coca-Cola. The quantity sold of Coca-Cola will drop from Q1 to Q2. This rise in prices will shift the demand curve and Pepsi which is ideally priced will rise in demand. And this is why Pepsi will be consumed more.
The formula of Cross elasticity of demand is
Cross elasticity of demand (XED) = {% change in QD good A} / {% Change in Price good B}
For example, if prices of Windows laptops drop by 10%, then the demand for Macbooks might fall by 5%. In this case, the XED of Windows laptops compared to Macbooks will be +0.5
Basis of this, these are 3 forms of substitutes
Close Substitute Goods
- Close substitutes are products that are very similar to each other and therefore can easily be substituted by each other. There will be a high cross-elasticity of demand in case of close substitutes.
- For example: If Coca-cola is not available, but Thumbs Up is available, you are likely to drink Thumbs Up.
Weak Substitute Goods
- Weak substitute goods are products that offer the same functionality but differ from each other in terms of features, quality or preferences.
- For Example: I want to buy JEEP as my next car. But a substitute to that is a Volkswagen sedan. Both products offer transportation as core functionality, but they are weaker substitutes to each other.
Perfect Substitutes
- Perfect substitutes are products or services that are identical to each and can easily be used in substition of each other.
- A simple example of substitutes are generic drugs vs branded drugs.
- The composition of generic drugs is the same as branded drugs but branded drugs are more in demand because of their marketing. Nonetheless, you will be perfectly fine using a generic drug instead of a branded drug.
Direct Substitute Goods
Direct Substitute Goods are similar enough to serve as a substitute. Two goods are direct substitutes if an increase in the price of one leads to an increase in the demand for the other. For example, if the price of good A rises, then consumers will purchase more of good B.
Substitutes that are identical to the original have a high cross-elasticity of demand. To put it another way, two products are readily exchangeable. In other words, the substitution effect is high. A 1% increase in the price of good A would lead to a more than 1% decline in the quantity demanded of good A.
For example, if the price of a Domino’ pizza rises by 1%, the quantity demanded of the Domino’s pizza would fall by more than 1%. This is because there are many other brands of pizza that consumers can purchase, such as Pizza Hut or Papa John’s.
Indirect Substitute Goods
Indirect Substitute goods are not similar enough to serve as a substitute. Two goods are indirect substitutes if an increase in the price of one does not lead to an increase in the demand for the other.
Substitutes that are not identical to the original have a low cross-elasticity of demand. In other words, the substitution effect is low. A 1% increase in the price of good A would lead to less than a 1% decline in the quantity demanded of good A.
For example, if the price of apples rises by 1%, the quantity demanded of oranges would not change. This is because apples and oranges are not close substitutes. They satisfy different needs though they both are fruits.
Direct substitutes are also understood as perfect substitutes, while indirect substitutes are also known as imperfect substitutes or less perfect substitutes.
Factors that Affect Substitute Goods
They are usually close substitutes, meaning that they satisfy the same needs or purposes. If substitute goods are close substitutes, then an increase in the price of the Substitute good will lead to a decrease in the demand for the good in question.
Conversely, if the substitute items are not close substitutes, then an increase in the price of the Substitute good will not have a significant effect on the demand for the good in question.
In addition to the price change, another factor that affects substitute items is quality. If the Substitute goods are of different quality, then an increase in the price of the Substitute good will not have a significant effect on the demand for the good in question.
Furthermore, if the Substitute goods are of the same quality, then an increase in the price of the Substitute good will lead to a decrease in the demand for the good in question. Lastly, these goods are also important in studying monopolies and oligopolies because they can exert downward pressure on prices charged by firms in these market structures.
In a monopoly, only one firm produces a good or service with no close substitute goods. This firm has the power to set prices.
In an oligopoly, there are a few firms that produce a good or service with no close substitute goods. These firms have the power to set prices. If there are substitute goods available in the market, then firms in a monopoly or oligopoly will be forced to lower their prices in order to compete. Thus, Substitute goods are important in the study of market power.
Why do consumers prefer substitutes?
The answer to this question is twofold. First, substitute goods are usually cheaper than the original good. Second, substitute goods often have better quality than the original good.
For example, if the price of a pizza at Domino’s rises by 1%, then consumers will purchase more Pizza Hut pizzas because they are cheaper. In addition, if the quality of Domino’s pizzas declines, then consumers will purchase more Pizza Hut pizzas because they are of better quality.
Let’s have a detailed look at the reasons behind the consumers’ selection of substitutes are
1. They are usually cheaper than the original good
As Substitute goods are usually cheaper, it becomes a reason for the consumers to switch from the original good to substituted goods. For example, if the price of a pizza at Domino’s rises by 1%, then consumers will purchase more Pizza Hut pizzas because they are cheaper.
2. They often have better quality than the original good
Another reason that supports the substituted goods over the original good is those substitute goods usually offer better quality to the consumers. It happens due to the competition in the market. To beat the competitors, substitute goods manufacturers try to improve the quality of their substituted goods so that more and more consumers get attracted to them. As a result, it becomes one of the significant reasons why consumers switch from the original good to Substitute goods.
3. They are easy to find
In today’s era, substituted goods are easily available in the market as compared to the original good. The availability of substituted goods has become easier because of globalization and technological advancement. With just a few clicks on our mobile phones or laptops, we can order Substitute goods from any part of the world.
4. They provide more options to the consumers
Substitute goods offer a wide range of options to consumers in terms of brand, quality, price, etc. This allows the consumers to choose the Substitute good as per their needs and preference. As a result, it becomes one of the significant reasons why Substitute goods are preferred over original goods.
5. They help in saving money
Substitute goods help consumers in saving a good amount of money. As Substitute goods are cheaper and offer more discounts and deals, it becomes easier for consumers to save money. In addition to this, Substitute goods also come with a warranty or guarantee which helps the consumers to get their Substitute goods repaired or replaced in case of any damage.
Thus, these are some of the reasons why Substitute goods are preferred over the original good by consumers.
10 Examples of Substitute Goods
Some of notable substitute goods examples are
1. Tuna and salmon
Fresh or canned tuna and salmon are two of the most frequently found fish in sushi restaurants. While the tastes of the two fish are different, they may be substituted for one another in a variety of dishes. If the price of salmon rises, customers may begin to demand tuna as a substitution.
2. Coke and Pepsi
Coca-Cola and Pepsi are the two most popular carbonated beverages in the world. The companies have engaged in a long-standing rivalry, with each trying to outdo the other in terms of marketing and product innovation. As such, customers often view these products as substitutes for one another.
3. Generic drugs and brand-name drugs
While generic drugs must contain the same active ingredient as their brand-name counterparts, they are often much cheaper. As a result, patients may ask their doctor for a generic substitution when filling a prescription.
4. Butter and margarine
Butter and margarine are two common spreads used in cooking and baking. While butter is made from cream, margarine is made from vegetable oil. Margarine is usually cheaper than butter and can be used as a substitute in many recipes.
5. Diamonds and cubic zirconia
Diamonds are the most popular gemstone for engagement rings and other fine jewelry. However, they are also very expensive. Cubic zirconia is a Substitute that is much cheaper but has a similar appearance.
6. Flour and cornstarch
Flour and cornstarch are two common thickeners used in cooking. While flour is made from wheat, cornstarch is made from corn. Cornstarch is often used as a substitute for flour because it is gluten-free.
7. Lumber and plywood
Lumber is a common material used in construction. However, it can be expensive. Plywood is a Substitute made from layers of wood veneer that are often used in place of lumber.
8. Beef and tofu
Beef and tofu are two common sources of protein. While beef is made from the flesh of cows, tofu is made from soybeans. Tofu is often used as a substitute for beef by vegetarians and vegans.
9. Silk and polyester
Silk is a luxurious fabric made from the fibers of silkworms. Polyester is a synthetic fabric that is cheaper and more durable than silk. Polyester is often used as a substitute for silk in clothing and home furnishings.
10. Gold and silver
Gold and silver are two precious metals that are often used in jewelry. While gold is more valuable, silver is less expensive. Silver is often used as a substitute for gold in costume jewelry.
Conclusion
Overall, it is important to understand the concept of Substitute Goods when discussing market competition. Substitute goods are those which can be used in place of one another. In monopolistic competition, cross-price elasticity is the key difference between the two types of goods.
A good with a low cross-price elasticity of demand is a complement to another good, while a good with high cross-price elasticity of demand is a substitute for another good. If the price increases, the demand for its substitutes will increase, while the demand for its complements will decrease.
When it comes to Substitute Goods, usually the price changes will have a bigger impact on the market competition than on other types of goods. This is because Substitute Goods are easily replaced by other similar products.
Thank you for reading about Substitute goods, direct substitute and indirect substitute
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