What is a Substitute?
A substitute, or substitutable good, in economics and consumer theory refers to a product or service that consumers consider to be essentially the same or sufficiently similar to another product. Simply put, a substitute is a good that can be used in place of another.
Substitutes play an important role in the market and are seen as a benefit to consumers. They offer more choice to consumers, who are then better able to meet their needs. BOMs often include alternate parts that can replace the standard part if it is destroyed.
Key points to remember
- A substitute is a product or service that can be easily replaced by another by consumers.
- In economics, products are often substitutes if the demand for one product increases when the price of the other increases.
- Substitutes provide choices and alternatives to consumers while creating competition and lower prices in the marketplace.
What is a substitute good?
When consumers make purchasing decisions, substitutes offer them alternatives. Substitutes occur when two or more products can be used for the same purpose, such as an iPhone versus an Android phone. For a product to substitute for another, it must share a particular relationship with this good. These relationships can be close, like one brand of coffee with another, or a bit more distant, like coffee and tea.
Giving consumers more choice helps generate competition in the market and, therefore, lowers prices. While this may be good for consumers, it may have the opposite effect on business results. Alternative products can reduce business profitability, as consumers may end up choosing one over another or see their market share diluted.
When looking at the relationship between the demand schedules of substitute products, if the price of a product increases, the demand for a substitute will tend to increase. This is because people will prefer a lower cost substitute to a more expensive one. If, for example, the price of coffee increases, the demand for tea may also increase as consumers switch from coffee to tea to maintain their budget.
Conversely, when the price of a good falls, the demand for its substitute may also fall. In formal economic parlance, X and Y are surrogates if the demand for X increases when the price of Y increases, or if there is a positive cross-elasticity of demand.
The availability of substitutes is one of Porter’s 5 forces, the others being competition, new entrants to the industry, supplier power and customer power.
Examples of Substitute Goods
Substitute goods are all around us. As mentioned above, they are usually used for the same purpose or are capable of fulfilling similar consumer needs.
Here are some examples of substitute goods:
- Currency: a dollar bill for 4 quarters (also called fungibility)
- Coke versus Pepsi
- Premium Gasoline vs. Regular Gasoline
- Butter and margarine
- Tea and coffee
- Apples and oranges
- Riding a bike versus driving a car
- E-books and regular books
There is one thing to keep in mind when dealing with substitutes: the degree to which one good is a substitute for another can, and often will be, different.
Perfect or less perfect substitutes
Classifying a product or service as a substitute is not always straightforward. There are varying degrees to which products or services can be defined as substitutes. A substitute can be perfect or imperfect depending on whether the substitute fully or partially satisfies the consumer.
A perfect substitute can be used in exactly the same way as the good or service it replaces. This is where the usefulness of the product or service is pretty much the same. For example, a dollar bill is a perfect substitute for another dollar bill. And butter from two different producers is also considered perfect substitutes; the producer may be different, but their purpose and use are the same.
A bicycle and a car are far from perfect substitutes, but they are similar enough that people use them to get from point A to point B. There is also a measurable relationship in the timing of demand. .
Although an imperfect substitute may be replaceable, there may be a degree of difference that is easily perceived by consumers. Thus, some consumers may choose to stick with one product over another. Consider Coke versus Pepsi. A consumer may choose Coke over Pepsi, perhaps because of taste, even if the price of Coke increases. If a consumer perceives a difference between brands of sodas, they may view Pepsi as an imperfect substitute for Coke, even though economists view them as perfect substitutes.
Less perfect substitutes are sometimes classified as gross substitutes or net substitutes by taking utility into account. A crude substitute is a substitute in which the demand for X increases when the price of Y increases. Net substitutes are those in which the demand for X increases when the price of Y increases and the utility derived from the substitute remains constant.
Substitute goods in perfect competition and in monopolistic competition
In case of perfect competition, perfect substitutes are sometimes conceived as nearly indistinguishable goods sold by different firms. For example, gasoline from a gas station on one corner may be virtually indistinguishable from gasoline sold by another gas station on the opposite corner. A price increase at a station will encourage more people to choose the cheaper option.
Monopolistic competition presents an interesting case that has complications with the concept of substitutes. In monopolistic competition, firms are not price takers, which means that demand is not very price sensitive. A common example is the difference between store brand and your local pharmacy’s brand name drug. The products themselves are nearly indistinguishable chemically, but they are not perfect substitutes due to the utility consumers may get – or believe they get – by buying a brand name rather than a drug. generic believing it to be more reputable or of better quality.