Substitute good

In microeconomics, substitute goods are two goods that can be used for the same purpose by consumers.^[1] That is, a consumer 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 goods and independent goods, substitute goods may replace each other in use due to changing economic conditions.^[2] An example of substitute goods is Coca-Cola and Pepsi; 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.^[3]

Substitute goods are commodity which the consumer demanded to be used in place of another good.

Economic theory describes two goods as being close substitutes if three conditions hold:^[3]

Performance characteristics describe what the product does for the customer; a solution to customers' needs or wants.^[3] For example, a beverage would quench a customer's thirst.

A product's occasion for use describes when, where and how it is used.^[3] 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.^[3]

Only if the two products satisfy the three conditions, will they be classified as close substitutes according to economic theory. The opposite of a substitute good is a complementary good, these are goods that are dependent on another. An example of complementary goods are cereal and milk.

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 occasions 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 and butter, and McDonald's and Burger King.

Formally, good $x_{j}$ is a substitute for good $x_{i}$ if when the price of $x_{i}$ rises the demand for $x_{j}$ rises, see figure 1.

Let $p_{i}$ be the price of good $x_{i}$ . Then, $x_{j}$ is a substitute for $x_{i}$ if: ${\frac {\partial x_{j}}{\partial p_{i}}}>0$ .

In perfect and monopolistic market structures[edit]

Perfect competition[edit]

Perfect competition is solely based on firms having equal conditions and the continuous pursuit of these conditions, regardless of the market size ^[17] One of the requirements for perfect competition 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.^[18] When this condition is not satisfied, the market is characterized by product differentiation. A perfectly competitive market is a theoretical benchmark and does not exist in reality. However, perfect substitutability is significant in the era of deregulation because there are usually several competing providers (e.g., electricity suppliers) selling the same good which result in aggressive price competition.

Monopolistic competition[edit]

Monopolistic competition 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 profits.^[19] 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.^[20] As a result of demand being very responsive to price changes, consumers will switch to the cheapest alternative as a result of price increases. This is known as switching costs, or essentially what the consumers are willing to give up.

Customers have slight switching costs between two available substitutes.

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.

The Michael Porter invented "Porter's Five Forces" to analyse an industry's attractiveness and likely profitability. 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:^[21]

Additionally substitute goods have a large impact on markets, consumer and sellers through the following factors:

Substitute good

In perfect and monopolistic market structures[edit]

Perfect competition[edit]

Monopolistic competition[edit]

Competitive equilibrium

Currency substitution

Fungible

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