What is a 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 if there is a positive cross elasticity of demand.
BREAKING DOWN Substitute
For a product to be a substitute for 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, such as 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 consumers 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.
Perfect Vs. Less Perfect Substitutes
In real life, brands may be considered substitutes, like Pepsi and Coke. Classifying a product or service as a substitute is not always straightforward. There are different degrees to which products or services can be defined as substitutes. A substitute can be perfect or imperfect depending on whether the substitute completely or partially satisfies the consumer. A perfect substitute is a product or service that can be used in exactly the same way as the good or service it replaces. This is where the utility of the product or service is pretty much identical. 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 relationship in the demand schedule.
If a consumer perceives a difference between these soda brands, he may see Pepsi as an imperfect substitute for Coke, even if economists might consider them perfect substitutes. Less perfect substitutes are sometimes classified as gross substitutes or net substitutes by factoring in utility. A substitute is defined as a gross substitute if the demand for X increases when the price of Y increases. Net substitutes describe substitutes if the demand for X increases when the price of Y increases and the 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 gasoline sold by a vendor on the opposite corner. (In reality, they may be the same good on the same demand schedule). 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 (or believe they get) from purchasing a brand name over a generic drug.