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.

  1. Supply

    A fundamental economic concept that describes the total amount ...
  2. Giffen Good

    A good for which demand increases as the price increases, and ...
  3. Parity Product

    A brand of good that has enough similarities with other brands ...
  4. Oversupply

    An excessive amount of a good or other substance. Oversupply ...
  5. Economics

    A social science that studies how individuals, governments, firms ...
  6. Elasticity

    A measure of a variable's sensitivity to a change in another ...
Related Articles
  1. Fundamental Analysis

    The Green Marketing Machine

    Don't let corporations greenwash their dirty laundry. Learn how to spot a phony.
  2. Entrepreneurship

    Cost-Push Inflation Versus Demand-Pull Inflation

    Gain a deeper understanding of aggregate supply and demand, forces which raise the price of goods and services.
  3. Professionals

    Advertising, Crocodiles And Moats

    Memorable advertising is a brick in the fortress that keeps competitors at bay.
  4. Fundamental Analysis

    The 4 R's Of Investing In Retail

    In retail, successfully managing return on investment (ROI) and other financial indicators is the key to a healthy business.
  5. Economics

    Understanding Supply-Side Economics

    Does the amount of goods and services produced set the pace for economic growth? Here are the arguments.
  6. Entrepreneurship

    2 Key Tactics Retailers Use To Increase Sales

    Many companies use versioning and bundling to increase sales. These strategies can offer value to consumers, but they also mean higher costs.
  7. Retirement

    Economic Indicators To Know

    The economy has a large impact on the market. Learn how to interpret the most important reports.
  8. Stock Analysis

    Markets Are Tanking: Time to Buy Like Buffett

    Learn about three value stocks Warren Buffett holds in his portfolio. See how Buffett uses market declines to find good deals on stocks.
  9. Stock Analysis

    The 6 Best Dividend Stocks in the Consumer Staples Sector

    Learn about the top six companies that make an attractive investment for investors looking for stocks for dividend income investing.
  10. Mutual Funds & ETFs

    Top 3 Consumer Cyclical Mutual Funds

    Obtain information on, and analysis of, some of the best performing mutual funds that offer exposure to the consumer cyclicals sector.
  1. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  2. How does price elasticity change in relation to supply and demand?

    The price elasticity of a product describes how sensitive suppliers and buyers are to changes in price. It doesn't change ... Read Full Answer >>
  3. What factors influence competition in microeconomics?

    From a microeconomics perspective, competition can be influenced by five basic factors: product features, the number of sellers, ... Read Full Answer >>
  4. What are some examples of the law of demand in real markets?

    The law of demand posits a negative relationship between the price of a good and quantity demanded if all other factors are ... Read Full Answer >>
  5. What are some examples of demand elasticity other than price elasticity of demand?

    Demand elasticity is an economic measure of the sensitivity of demand relative to a change in another variable. The quantity ... Read Full Answer >>
  6. Which factors are more important in determining the demand elasticity of a good or ...

    Demand elasticity measures how sensitive the quantity demanded of a good or service is to changes in other variables. Many ... Read Full Answer >>
  7. What factors influence a change in demand elasticity?

    Demand elasticity is the sensitivity of the demand for a good or service due to a change in another factor. There are many ... Read Full Answer >>
  8. How would a true market economy ensure that the world never runs out of oil

    The physical supply of oil will never run out in an economic system where prices are allowed to fluctuate based on supply ... Read Full Answer >>
  9. What is the long-term outlook of the metals and mining sector?

    An industry agency council was established by the World Economic Forum in 2014 to serve as an advisory board on the future ... Read Full Answer >>
  10. How does fracking affect oil prices?

    Hydraulic fracturing has helped boost the rate at which oil and gas can be extracted from wells, particularly in the United ... Read Full Answer >>
  11. What are some limitations of the consumer price index (CPI)?

    The consumer price index, or CPI, is considered one of the most fundamental and critically important economic indicators, ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  2. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  3. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  4. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  5. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  6. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!