The presence of substitution affects elasticity because it provides alternative choices in consuming products or services
If a substitute product is available, consumers tend to turn to these alternative products when the price of a product or service rises. Of course, by switching, they get lower prices. Product demand is inelastic when there is no substitute or little available. In contrast, when there are many substitutions available, the demand is elastic.
Definition of substitute product and elasticity
Substitute product is an alternative product that provides similar satisfaction. Remember, in economics, another term for product satisfaction is utility. When alternative products offer the same utility, we say they are perfect substitutions. When not the same, they are imperfect substitutes or close substitutions.
Perfect substitutes exist in perfect competition markets. Its availability in the market makes producers only as price takers. Once they raise prices above market prices, consumers will switch and ask for substitute products.
How responsive is demand when the price of a product changes, that is what we call own-price elasticity of demand. We measure it by dividing the percentage change in the quantity of demand for an item by the percentage change in its price.
Why does substitution affect elasticity
In economics, economists assume consumers as rational beings. When faced with two items with similar utilities, they will choose the cheapest.
Because substitute products offer a similar utility, they will choose it when the price of an item rises. Thus, the availability of substitute goods affects the elasticity of demand for goods or services.
Demand for goods or services with many elastic substitutes because consumers have many choices. That means, when the price of an item rises slightly, consumers will switch to its substitute.
Consider two soap products with different brands. Both offer the same quality. A decrease in price in one brand encourages you to buy it. In contrast, a price increase encourages you to purchase an alternative brand.
Likewise, with Pepsi and Coca Cola. An increase in Coca Cola prices encourages you to prefer Pepsi, and the opposite effect applies when Coca Cola prices go down.
Furthermore, when there is little or no good substitute for an item, demand is inelastic. Consumers will continue to buy products even if prices rise because they have no alternative.
Consider the cancer drugs you take while you are on treatment. If two pills per day keep you alive, you can’t possibly reduce purchases even if the price goes up. Also, you are not likely to increase purchases even if prices fall.
Does only the price of substitute products affect consumer demand?
No, the other determining factor is switching costs. That is the cost that the consumer bears (such as transportation costs and time) to get a substitute product.