What Is a Substitute?

A substitute, or substitute good, in economics and consumer theory is a product or service a consumer sees as the same or similar to another product. Put simply, a substitute is a good that can be used in place of another.

In formal economic language, X and Y are substitutes if demand for X increases when the price of Y increases, or if there is a positive cross elasticity of demand.

Substitutes play an important part in the marketplace and are considered a benefit for consumers. They provide more choices for consumers, who are better able to satisfy their needs.

Understanding Substitutes

When consumers make buying decisions, substitutes provide them with alternatives. Generally, there are at least two products that can be used for the same purpose. For a product to be a substitute for another, 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.

Giving consumers more choice helps generate competition in the market. While that may be good for people, it may have the opposite effect on companies. Alternative products may cut into companies' profitability, as consumers may end up choosing one more over another.

When you examine the relationship of the demand schedules of these products, demand for its substitute increases as the price of a good goes up. If, for example, the price of coffee increases, the demand for tea may also increase as consumers switch rom coffee to tea to maintain their budgets. Conversely, when a good's price decreases, the demand for its substitute may also decrease.

[Important: Substitutes are one of Porter's 5 Forces—the others being competition, new entrants into the industry, the power of suppliers, and the power of customers.]

Examples of Substitute Goods

Substitute good are all around us. As mentioned above, they are generally used for the same purpose and are able to satisfy the needs of consumers.

Here are a few examples of substitute goods:

  • Currency: a dollar for a dollar
  • 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 it comes to substitutes: the degree to which a good is a substitute for another can differ.

Key Takeaways

  • A substitute is a product or service that can be easily replaced with another.
  • In economics, products are substitutes if demand for one product increases when the price of the other increase.
  • Substitutes provide choices and alternatives for consumers, while creating competition in the marketplace.

Perfect vs. Less Perfect Substitutes

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 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. For example, a one-dollar bill is a perfect substitute for another dollar bill. And butter from two different producers are also considered perfect substitutes—the producer may be different, but their purpose and usage is the same.

A bike and a car are far from perfect substitutes, but they are similar enough for people to use them to get from point A to point B. There is also some measurable relationship in the demand schedule.

Although an imperfect substitute may be replaceable, it may have a degree of difference that can be easily perceived by consumers. So some consumers may choose to stick with one product over the other. Consider Coke versus Pepsi. A consumer may choose Coke over Pepsi—perhaps because of taste—even if the price of Coke goes up. If a consumer perceives a difference between soda brands, he may see Pepsi as an imperfect substitute for Coke—even if economists consider them perfect substitutes.

Less perfect substitutes are sometimes classified as gross substitutes or net substitutes by factoring in utility. A gross substitute is one in which demand for X increases when the price of Y increases. Net substitutes are those in which 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. An increase in the price 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 monopolistic competition, companies are not price-takers, meaning demand is not highly sensitive to price. A common example is the difference between store brand and branded medicine 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.