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.

RELATED TERMS
  1. Income Effect

    The income effect is the change in demand for a good or service ...
  2. Asset Substitution Problem

    An asset substitution problem arises when low risk assets are ...
  3. Demand Theory

    Demand theory is a principle relating to the relationship between ...
  4. Marginal Rate of Technical Substitution

    The marginal rate of technical substitution is the rate at which ...
  5. Low-Cost Producer

    A low-cost producer is a company that can provide goods or services ...
  6. Declining Industry

    A declining industry is an industry where growth is either negative ...
Related Articles
  1. Insights

    Understanding the Substitution Effect

    The substitution effect is an economic term used to describe consumer behavior relative to price or income changes.
  2. Investing

    Do Oil Prices Affect The Auto Industry?

    Based on an understanding of complementary and substitute goods, the American auto industry is exhibiting expected effects from the recent plunge in the price of oil.
  3. Investing

    Calculating Cross Elasticity of Demand

    Cross elasticity of demand measures the quantity demanded of one good in response to a change in price of another.
  4. Insights

    Why We Splurge When Times Are Good

    The concept of elasticity of demand is part of every purchase you make. Find out how it works.
  5. Investing

    Analyzing Porter's Five Forces on Delta Airlines (DAL)

    Learn about Porter's Five Forces, a framework used to analyze external threats to companies, and discover which forces pose the biggest threats to Delta.
  6. Investing

    Starbucks - Porter's 5 Forces

    Even though Starbucks is a well established company, there is always a threat from competitive forces.
RELATED FAQS
  1. Is the substitution effect negative for consumers?

    Explore whether the substitution effect is positive or negative for consumers as well as for retailers, manufacturers and ... Read Answer >>
  2. What happens when M2 money supply grows faster than the overall economy?

    Find out what happens if the total supply of money and money substitutes expands at a faster rate than the productive output ... Read Answer >>
  3. What is the difference between a monopolistic market and perfect competition?

    Learn about monopolistic and perfectly competitive markets, what they are, and the main differences between perfect competition ... Read Answer >>
  4. Does perfect competition exist in the real world?

    There are significant obstacles preventing perfect competition in today's economy, and many economists think it is better ... Read Answer >>
  5. What is the utility function and how is it calculated?

    Economists measure utility in revealed preferences by observing consumer choices and ordering consumption baskets from least ... Read Answer >>
  6. Is demand or supply more important to the economy?

    Learn more about the impact of supply and demand in an economy. Find out why companies study supply and demand as part of ... Read Answer >>
Trading Center