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Substitute goods refer to two or more goods that meet similar needs, so they become alternatives to each other. For example, Coca-Cola is a close substitute for Pepsi.
Because it is an alternative, consumers switch to their substitutes when the price of an item rises. Rising the Coca-Cola price will encourage some people to turn to Pepsi. In contrast, when the price of Pepsi rises, consumers switch to Coca-Cola.
The cross-price elasticity of demand
Consumers will choose the cheaper one when two goods replace each other. Thus, the demand for a product positively correlates to the price of the substitute product. In economics, we say both products have a positive cross-price elasticity because if the price of one item increases, the demand for substitutes will rise.
Elasticity measures the responsiveness of the demand for an item when the price changes. Because it involves the price of other goods (not its own price), then we call it cross elasticity.
Cross-price elasticity =% change in the demand quantity of good X /% change in the price of good Y
Two substituting products have positive elasticity. An increase in the price of a product will encourage consumers to choose substitutes.
In contrast, cross-price elasticity will be negative if the two items complement each other. Two goods are complement if the consumption of one item requires the use of another. For example, gasoline and cars. An increase in the car price causes sales to fall, reducing demand for gasoline. Other examples are inkjet printers and ink cartridges.
Types of substitute goods
The value of cross-price elasticity tells us how close the two products substitute one another.
A high elasticity value indicates that the product is a close substitute. If the price of one item rises only in small quantities, the demand for its alternatives will increase significantly.
Substitution is weak if the elasticity value is low. A high change in its substitute price has little effect on the demand for a product.
Two goods are perfect substitutes when consumers get the exact same utility. Customers choose based on price, and other factors have no influence on demand. Therefore, it is impossible to build brand equity so that customers prefer one. An example is the services offered by wireless operators.
Furthermore, imperfect substitutes (whether close or weak substitutions) do not have equal utility as original goods. Imperfect substitutions have lower substitution rates, and therefore show marginal substitution rates that vary along the consumer’s indifference curve.
Examples of substitute goods
Some cases of two items that substitute each other are:
- Butter and margarine
- Cars and motorbikes
- Tea and Coffee
- Pens and Pencils
- Laptop and personal computer
- Coca-Cola and Pepsi
- Burger King and McDonald’s burgers
- Android mobile and Apple iPhone
- The Wall Street Journal and New York Times
Implications
Substitution products provide alternative choices for consumers while they also raise a tighter competition in the market. Consumers can choose an original product or its substitution, which is cheaper or quality.
In Porter’s Five Forces Model, substitution presents a threat to a company or industry profitability. That is because substitution offers similar benefits as the company provides. So, when consumers switch to Pepsi because of lower prices, it can threaten Coca-Cola sales.
In general, the more substitutions available, the more elastic the demand. A small increase in the price of a product will cause a significant decrease in order because consumers begin to buy more substitute goods.
The threat is high when it substitutes perfectly. Also, the risk of substitution is high when:
- Consumers bear small switching costs
- Consumers are not loyal and sensitive to price changes
- The performance and quality of substitute products are superior
- Product differentiation is low compared to its substitution
- Substitution products are widely available in the market
Market structure
Perfect substitution is a characteristic of perfect competition. In this market structure, consumers can easily switch to substitute products and get the same utility without bearing switching costs.
Meanwhile, monopolistic and oligopolistic competition markets face imperfect substitution. Producers can differentiate their offers, for example, through branding and advertising. Through this differentiation, companies can charge prices higher than market prices. They are not price takers, but price searchers.
Furthermore, the monopoly market works if there is no substitution (or very low). That way, monopolists can control the market, and consumers want to buy their products. If substitutions are present and operate competitively, then consumers will turn to them because the price will tend to be cheaper and of better quality.
