Substitute

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DEFINITION of 'Substitute'

A "substitute" or "substitute good" in economics and consumer theory is a product or service that a consumer sees as the same or similar to another product. In the formal language of economics, X and Y are substitutes if the demand for X increases when the price of Y increases, or a positive cross elasticity of demand.

BREAKING DOWN 'Substitute'

For a product to be a substitute of another good, it must share a particular relationship with that good. Those relationships can be close, like one brand of coffee with another, or somewhat further apart like coffee and tea. When you examine the relationship of the demand schedules of these products, you'll see that as the price of  a good goes up, the demand for its substitute increases. If, for example, the price of coffee increases, the demand for tea may also increase as consumer switch away from coffee to tea to maintain their budgets. Conversely, when a good's price decreases, the demand for its substitute may also decrease. 

In real life, brands may be considered substitutes, like Pepsi (PEP) and Coke (KO). A substitute can be perfect or imperfect depending on whether the substitute completely or partially satisfies the consumer. If a consumer sees a difference in these brands, he may see Pepsi as an imperfect substitute for Coke, even if economists might consider them perfect substitutes.

Classifying a product or service as a substitute is not always a straightforward practice. There are different degrees to which products or services can be defined as substitutes. A perfect substitute is a product or service that can be used in the exact same way as the good or service it replaces. This is where the utility of the product or service the exact same. A bike and a car are far from perfect substitutes, but they're similar in that people use them to get from point A to point B and there is some measurable change in the demand schedule.

To differentiate the utility difference in substitutes, they are sometimes classified as gross substitutes and net substitutes. Gross substitutes are defined as substitutes if the demand for X increases when the price of Y increases. Net substitutes describe substitutes when the demand for X increases when the price of Y increases and utility derived from the substitute remains constant.

Perfect Competition and Monopolistic Competition

In cases of perfect competition, perfect substitutes are sometimes conceived as nearly indistinguishable goods being sold by different firms. For example, gasoline from a vendor on one corner may be indistinguishable from the gasoline being sold by a vendor on the opposite corner. (In reality they may be the same good one the same demand scale.) An increase in the price of gas at one station will have a perfectly correlated effect on the increase in demand at the other station.

Monopolistic competition presents an interesting case of complications with the concept of perfect substitutes. In cases of monopolistic competition, companies are not price takers, meaning that demand is not highly sensitive to price. A common example is the difference between store brand medicine and branded medicine on the shelf at your local pharmacy. The products themselves are nearly indistinguishable, but they are not perfect substitutes due to the utility consumers may get from purchasing a brand name over a generic drug.

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