TheInfoList

In
microeconomics Microeconomics is a branch of mainstream economics Mainstream economics is the body of knowledge, theories, and models of economics, as taught by universities worldwide, that are generally accepted by economists as a basis for discussion. Als ...
, two goods are substitutes if the products could be used for the same purpose by the consumers. That is, a
consumer A consumer is a person or a group who intends to order, orders, or uses purchased goods, products, or Service (economics), services primarily for personal, social, family, household and similar needs, not directly related to entrepreneurial or bu ...
perceives both goods as similar or comparable, so that having more of one good causes the consumer to desire less of the other good. Contrary to
complementary good A complement is often something that completes something else, or at least adds to it in some useful way. Thus it may be: * Complement (linguistics) In grammar In linguistics Linguistics is the scientific study of language, meaning th ...
s and
independent goods Independent goods are Good (economics), goods that have a zero cross elasticity of demand. Changes in the price of one good will have no effect on the Demand (economics), demand for an independent good. Thus independent goods are neither compleme ...
, substitute goods may replace each other in use due to changing economic conditions. An example of substitute goods is
Coca-Cola Coca-Cola, or Coke, is a carbonated Carbonation is the chemical reaction A chemical reaction is a process that leads to the chemical transformation of one set of chemical substances to another. Classically, chemical A chemical sub ...

and
Pepsi Pepsi is a carbonated Carbonation is the chemical reaction A chemical reaction is a process that leads to the chemical transformation of one set of chemical substances to another. Classically, chemical A chemical substance is a form of ...

; the interchangeable aspect of these goods is due to the similarity of the purpose they serve, i.e fulfilling customers' desire for a soft drink. These types of substitutes can be referred to as close substitutes.

# Definition

Economic theory describes two goods as being close substitutes if three conditions hold: # products have the same or similar performance characteristics # products have the same or similar occasion for use and # products are sold in the same geographic area Performance characteristics describe what the product does for the customer. For example, a beverage would quench a customer's thirst. A product's occasion for use describes when, where and how it is used. For example, orange juice and soft drinks are both beverages but are used by consumers in different occasions (i.e. breakfast vs during the day). Two products are in different geographic market if they are sold in different locations, it is costly to transport the goods or it is costly for consumers to travel to buy the goods. Only if the two products satisfy the three conditions, will they be classified as close substitutes according to economic theory. An example of substitute goods are tea and coffee. These two goods satisfy the three conditions: tea and coffee have similar performance characteristics (they quench a thirst), they both have similar occasion for use (in the morning) and both are usually sold in the same geographic area (consumers can buy both at their local supermarket). Some other common examples include
margarine Margarine (, also , ) is a spread used for flavoring, baking and cooking. It is most often used as a substitute for butter. Although originally made from animal fats, most margarine consumed today is made from vegetable oil. The foodstuff was or ...

and
butter Butter is a dairy product Dairy products or milk products are a type of food Food is any substance consumed to provide Nutrient, nutritional support for an organism. Food is usually of plant, animal or Fungus, fungal origin, and contai ...

, and
McDonald's McDonald's is an American fast food Fast food is a type of Mass production, mass-produced food designed for commercial resale and with a strong priority placed on "speed of service" versus other relevant factors involved in food scie ...

and
Burger King Burger King (BK) is an American multinational chain A chain is a assembly of connected pieces, called links, typically made of metal, with an overall character similar to that of a in that it is flexible and d in but , rigid, and lo ...

. Formally, good $x_j$ is a substitute for good $x_i$ if when the
price A price is the (usually not negative) quantity Quantity is a property that can exist as a multitude or magnitude, which illustrate discontinuity and continuity. Quantities can be compared in terms of "more", "less", or "equal", or b ...

of $x_i$ rises the
demand In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plant ...

for $x_j$ rises, see figure 1. Let $p_i$ be the
price A price is the (usually not negative) quantity Quantity is a property that can exist as a multitude or magnitude, which illustrate discontinuity and continuity. Quantities can be compared in terms of "more", "less", or "equal", or b ...

of good $x_i$. Then, $x_j$ is a substitute for $x_i$ if: $\frac >0$.

# Cross elasticity of demand

The fact that one good is substitutable for another has immediate economic consequences: insofar as one good can be substituted for another, the
demand In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plant ...

s for the two goods will be interrelated by the fact that customers can trade off one good for the other if it becomes advantageous to do so. Cross-price elasticity helps us understand the degree of substitutability of the two products. An increase in the price of a good will (''
ceteris paribus ' or ' () is a Latin phrase meaning "other things equal"; English translations of the phrase include "all other things being equal" or "other things held constant" or "all else unchanged". A prediction or a statement about a ontic, causal, epist ...
'') increase demand for its substitutes, while a decrease in the price of a good will decrease demand for its substitutes, see Figure 2. The relationship between determines whether goods are classified as substitutes or complements. The
cross-price elasticity of demand In economics, the cross elasticity of demand or cross-price elasticity of demand measures the percentage change of the quantity demanded for a Good (economics), good to the percentage change in the price of another good, ceteris paribus. In real lif ...
shows the relationship between two goods, it captures the responsiveness of the quantity demanded of one good to a change in price of another good. Cross-Price Elasticity of Demand (''E''x,y) is calculated with the following formula: ''E''x,y = Percentage Change in Quantity Demanded for Good X / Percentage Change in Price of Good Y The cross-price elasticity may be positive or negative, depending on whether the goods are complements or substitutes. A substitute good is a good with a positive cross elasticity of demand. This means that, if good $x_j$ is a substitute for good $x_i$, an increase in the price of $x_i$ will result in a leftward movement along the demand curve of $x_i$ and cause the demand curve for $x_j$ to
shift out Shift Out (SO) and Shift In (SI) are ASCII ASCII ( ), abbreviated from American Standard Code for Information Interchange, is a character encoding In computing Computing is any goal-oriented activity requiring, benefiting from, or creat ...
. A decrease in the price of $x_i$ will result in a rightward movement along the demand curve of $x_i$ and cause the demand curve for $x_j$ to
shift in Shift Out (SO) and Shift In (SI) are ASCII ASCII ( ), abbreviated from American Standard Code for Information Interchange, is a character encoding In computing Computing is any goal-oriented activity requiring, benefiting from, or creat ...
. Furthermore, perfect substitutes have a higher cross elasticity of demand than imperfect substitutes do.

# Types

## Perfect and imperfect substitutes

### Perfect substitutes

Perfect substitutes refer to a pair of goods with uses identical to one another. In that case, the
utility As a topic of economics Economics () is a social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among individuals within thos ...

of a combination of the two goods is an increasing function of the sum of the quantity of each good. That is, the more the consumer can consume (in total quantity), the higher level of utility will be achieved, see figure 3. Perfect substitutes have a
linear utilityIn economics and consumer theory, a linear utility function is a function of the form: ::u(x_1,x_2,\dots,x_m) = w_1 x_1 + w_2 x_2 + \dots w_m x_m or, in vector form: ::u(\overrightarrow) = \overrightarrow \cdot \overrightarrow where: * m is the nu ...
function and a constant
marginal rate of substitution In economics, the marginal rate of substitution (MRS) is the rate at which a consumer can give up some amount of one good in exchange for another good while maintaining the same level of utility As a topic of economics Economics () is ...
, see figure 3. If goods X and Y are perfect substitutes, any different consumption bundle will result in the consumer obtaining the same utility level for all the points on the indifference curve (utility function). Let a consumption bundle be represented by (X,Y), then, a consumer of perfect substitutes would receive the same level of utility from (20,10) or (30,0). Consumers of perfect substitutes base their rational decision making process on prices only. Evidently, the consumer will choose the cheapest bundle. If the prices of the goods differed, there would be no demand for the more expensive good. Producers and sellers of perfect substitute goods directly compete with each other, that is, they are known to be in direct
price competition Price war is "commercial competition characterized by the repeated cutting of prices below those of competitors". One competitor will lower its price, then others will lower their prices to match. If one of them reduces their price again, a new ro ...
. An example of perfect substitutes is butter from two different producers; the producer may be different but their purpose and usage are the same. Perfect substitutes have a high cross-elasticity of demand. For example, if
Country Crock Country Crock is a food brand owned by Upfield (company), Upfield. It originally sold spreads such as margarine (and cheese for a limited time), but later extended to side dishes, particularly mashed potatoes and pasta, made by Hormel under license ...
and
Imperial margarine Imperial is a brand of margarine or Spread (food), spread, depending on the country, previously distributed by Unilever and currently marketed by Upfield (company), Upfield. It is best remembered for television commercials in which a person who rec ...
have the same price listed for the same amount of spread, but one brand increases its price, its sales will fall by a certain amount. In response, the other brand's sales will increase by the same amount.

### Imperfect substitutes

Imperfect substitutes, also known as close substitutes, have a lesser level of substitutability, and therefore exhibit variable marginal rates of substitution along the consumer
indifference curve In economics Economics () is a social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behavi ...

. The consumption points on the curve offer the same level of utility as before, but compensation depends on the starting point of the substitution. Unlike perfect substitutes (see figure 4), the indifference curves of imperfect substitutes are not linear and the marginal rate of substitution is different for different set of combinations on the curve. Close substitute goods are similar products that target the same customer groups and satisfy the same needs, but have slight differences in characteristics. Sellers of close substitute goods are therefore in indirect competition with each other. Beverages are an example. As the price of Coca-Cola rises, consumers could be expected to substitute Pepsi. However, many consumers prefer one brand over the other. Consumers who prefer one brand over the other will not trade between them one-to-one. Rather, a consumer who prefers Coca-Cola (for example) will be willing to exchange more Pepsi for less Coca-Cola. The degree to which a good has a perfect substitute depends on how specifically the good is defined. The broader the definition of a good, the easier it is for the good to have a substitute good. On the other hand, a good narrowly defined will be likely to not have a substitute good. For example, different types of cereal generally are substitutes for each other, but
Rice Krispies Rice Krispies (known as Rice Bubbles in Australia Australia, officially the Commonwealth of Australia, is a Sovereign state, sovereign country comprising the mainland of the Australia (continent), Australian continent, the island of ...
cereal, which is a very narrowly defined good as compared to cereal generally, has few, if any substitutes. To illustrate this further, we can imagine that while both Rice Krispies and
Froot Loops Froot Loops is a brand of sweetened, fruit-flavored breakfast cereal produced by Kellogg's and sold in many countries. The cereal pieces are ring-shaped (hence "loops") and come in a variety of bright colors and a blend of fruit flavors (hence ...
are types of cereal, they are imperfect substitutes, as the two are very different types of cereal. However, generic brands of Rice Krispies, such as Malt-o-Meal's Crispy Rice would be a perfect substitute for Kellogg's Rice Krispies. Imperfect substitutes have a low cross-elasticity of demand. If two brands of cereal have the same prices before one's price is raised, we can expect sales to fall for that brand. However, sales will not raise by the same amount for the other brand, as there are many types of cereal that are equally substitutable for the brand which has raised its price; consumer preferences determine which brands pick up their losses.

## Gross and net substitutes

If two goods are imperfect substitutes, economists can distinguish them as gross substitutes or net substitutes. Good $x_j$ is a gross substitute for good $x_i$ if, when the price of good $x_i$ increases, spending on good $x_j$ increases, as described above. Gross substitutability is not a symmetric relationship. Even if $x_j$ is a gross substitute for $x_i$, it may not be true that $x_i$ is a gross substitute for $x_j$. Two goods are net substitutes when the demand for good X increases when the price of good Y increases and the utility derived from the substitute remains constant. Goods $x_i$ and $x_j$ are said to be net substitutes if :$\left.\frac\_>0$ That is, goods are net substitutes if they are substitutes for each other under a constant utility function. Net substitutability has the desirable property that, unlike gross substitutability, it is symmetric: :$\left.\frac\_ = \left.\frac\_$ That is, if good $x_j$ is a net substitute for good $x_i$, then good $x_i$ is also a net substitute for good $x_j$. The symmetry of net substitution is both intuitively appealing and theoretically useful. The common misconception is that
competitive equilibrium Competitive equilibrium (also called: Walrasian equilibrium) is a concept of economic equilibrium introduced by Kenneth Arrow and Gérard Debreu in 1951 appropriate for the analysis of commodity markets with flexible prices and many traders, and ser ...
is non-existent when it comes to products that are net substitutes. Like most times when products are gross substitutes, they will also likely be net substitutes, hence most gross substitute preferences supporting a competitive equilibrium also serve as examples of net substitutes doing the same. This misconception can be further clarified by looking at the nature of net substitutes which exists in a purely hypothetical situation where a fictitious entity interferes to shut down the
income effect The theory of consumer choice is the branch of microeconomics Microeconomics is a branch of mainstream economics Mainstream economics is the body of knowledge, theories, and models of economics, as taught by universities worldwide, that ar ...

and maintain a constant utility function. This defeats the point of a competitive equilibrium, where no such intervention takes place. The equilibrium is decentralized and left to the producers and consumers to determine and arrive at an equilibrium price.

## Within-category and cross-category substitutes

Within-category substitutes are goods that are members of the same taxonomic category such as goods sharing common attributes (e.g., chocolate, chairs, station wagons). Cross-category substitutes are goods that are members of different taxonomic categories but can satisfy the same goal. A person who wants chocolate but cannot acquire it, for example, might instead buy ice cream to satisfy the goal of having a dessert. Whether goods are cross-category or within-category substitutes influences the utility derived by consumers. People exhibit a strong preference for within-category substitutes over cross-category substitutes, despite cross-category substitutes being more effective at satisfying customers' needs. Across ten sets of different foods, 79.7% of research participants believed that a within-category substitute would better satisfy their craving for a food they could not have than a cross-category substitute. Unable to acquire a desired Godiva chocolate, for instance, a majority reported that they would prefer to eat a store-brand chocolate (a within-category substitute) than a chocolate-chip
granola bar Granola is a breakfast and snack food consisting of rolled oats, nut (fruit), nuts, honey or other Sugar substitute, sweeteners such as brown sugar, and sometimes puffed rice, that is usually baked until it is crisp, toasted and golden brown. D ...

(a cross-category substitute). This preference for within-category substitutes appears, however, to be misguided. Because within-category substitutes are more similar to the missing good, their inferiority to it is more noticeable. This creates a negative
contrast effect A contrast effect is the enhancement or diminishment, relative to normal, of perception, cognition or related performance as a result of successive (immediately previous) or simultaneous exposure to a stimulus (physiology), stimulus of lesser or ...
, and leads within-category substitutes to be less satisfying substitutes than cross-category substitutes.

## Unit-demand goods

Unit-demand goods are categories of goods from which consumer wants only a single item. If the consumer has two unit-demand items, then his utility is the ''maximum'' of the utilities he gains from each of these items. For example, consider a consumer that wants a means of transportation, which may be either a car or a bicycle. The consumer prefers a car to a bicycle. If the consumer has both a car and a bicycle, then the consumer uses only the car. Unit-demand goods are always substitutes.

# In perfect and monopolistic market structures

## Perfect competition

One of the requirements for
perfect competition In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plant ...
is that the goods of competing firms should be perfect substitutes. Products sold by different firms have minimal differences in capabilities, features, and pricing. Thus, buyers cannot distinguish between products based on physical attributes or intangible value. When this condition is not satisfied, the market is characterized by
product differentiation In economics Economics () is a social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behavio ...
. A perfectly competitive market is a theoretical benchmark and does not exist in reality. However, perfect substitutability is significant in the era of
deregulation Deregulation is the process of removing or reducing state regulations, typically in the economic sphere. It is the repeal of governmental regulation of the economy. It became common in advanced industrial economies in the 1970s and 1980s, as a ...
because there are usually several competing providers (e.g., electricity suppliers) selling the same good which result in aggressive
price competition Price war is "commercial competition characterized by the repeated cutting of prices below those of competitors". One competitor will lower its price, then others will lower their prices to match. If one of them reduces their price again, a new ro ...
.

## Monopolistic competition

Monopolistic competition Monopolistic competition is a type of imperfect competitionIn economics, imperfect competition refers to a situation where the characteristics of an economic market do not fulfil all the necessary conditions of a perfectly competitive market, ...
characterizes an industry in which many firms offer products or services that are close, but not perfect substitutes. Monopolistic firms have little power to set curtail supply or raise prices to increase
profit Profit may refer to: Business and law * Profit (accounting) Profit, in accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic ...
s. Thus, the firms will try to differentiate their product through branding and marketing to capture above market returns. Some common examples of monopolistic industries include gasoline, milk, Internet connectivity (ISP services), electricity, telephony, and airline tickets. Since firms offer similar products, demand is highly elastic in monopolistic competition. As a result of demand being very responsive to price changes, consumers will switch to the cheapest alternative as a result of price increases.

# Market effects

The Michael Porter invented "Porter's Five Forces" to analyse an industry's attractiveness and likely
profitability An economic profit is the difference between the revenue a commercial entity has received from its outputs and the opportunity cost In microeconomic theory Microeconomics (from Greek prefix ''mikro-'' meaning "small" + ''economics'') ...

. Alongside competitive rivalry, buyer power, supplier power and threat of new entry, Porter identifies the threat of substitution as one of the five important industry forces. The threat of substitution refers to the likelihood of customers finding alternative products to purchase. When close substitutes are available, customers can easily and quickly forgo buying a company's product by finding other alternatives. This can weaken a company's power which threatens long-term profitability. The risk of substitution can be considered high when: * Customers have slight switching costs between the two substitutes available. * The quality and performance offered by a close substitute are of a higher standard. * Customers of a product have low loyalty towards the brand or product, hence being more sensitive to price changes. Additionally substitute goods have a large impact on markets, consumer and sellers through the following factors: # Markets characterised by close/perfect substitute goods experience great volatility in prices. This volatility negatively impacts producers' profits, as it is possible to earn higher profits in markets with fewer substitute products. That is, perfect substitute results in profits being driven down to zero as seen in perfectly competitive markets equilibrium. # As a result of the intense competition caused the availability of substitute goods, low quality products can arise. Since prices are reduced to capture a larger share of the market, firms try to utilise the least amount of resources to reduce their costs. # In a market with close/perfect substitutes, customers have a wide range of products to choose from. As the number of substitutes increase, the probability that every consumer selects what is right for them also increases. That is, consumers can reach a higher overall utility level from the availability of substitute products.