thumb|Petrol from two [[Competition (economics)|competing petrol station chains (Amoco and Gulf Oil) are substitute goods.]]
In microeconomics, substitute goods are two goods that can be used for the same purpose by consumers. That is, a consumer perceives both goods as similar or comparable, so that having more of one good causes the consumer to desire less of the other good. Contrary to complementary goods and independent goods, substitute goods may replace each other in use due to changing economic conditions. An example of substitute goods is Coca-Cola and Pepsi; the interchangeable aspect of these goods is due to the similarity of the purpose they serve, i.e. fulfilling customers' desire for a cola-flavored soft drink. These types of substitutes can be referred to as close substitutes.
- products have the same or similar performance characteristics
- products have the same or similar occasion for use
- products are sold in the same geographic area
thumb|245x245px|Figure 1: If the price of <math>x_i</math> increases, then demand for <math>x_j</math> increases
Performance characteristics describe what the product does for the customer; a solution to customers' needs or wants.
thumb|433x433px|Figure 2: Graphical example of substitute goods
The relationship between demand schedules determines whether goods are classified as substitutes or complements. The cross-elasticity of demand shows the relationship between two goods, it captures the responsiveness of the quantity demanded of one good to a change in price of another good.
Cross-elasticity of demand (<math>\text{XED}</math>) is calculated with the following formula:
<math>\text{XED}
= \frac{\%\text{ change in quantity demanded of good A{\%\text{ change in price of good B</math>
The cross-elasticity may be positive or negative, depending on whether the goods are complements or substitutes. A substitute good is a good with a positive cross elasticity of demand. This means that, if good <math>x_j</math> is a substitute for good <math>x_i</math>, an increase in the price of <math>x_i</math> will result in a leftward movement along the demand curve of <math>x_i</math> and cause the demand curve for <math>x_j</math> to shift out. A decrease in the price of <math>x_i</math> will result in a rightward movement along the demand curve of <math>x_i</math> and cause the demand curve for <math>x_j</math> to shift in. Furthermore, perfect substitutes have a higher cross elasticity of demand than imperfect substitutes do.
Types
thumb|Figure 3: Utility functions of perfect substitutes
Perfect and imperfect substitutes
Perfect substitutes
Perfect substitutes refer to a pair of goods with uses identical to one another. In that case, the utility of a combination of the two goods is an increasing function of the sum of the quantity of each good. That is, the more the consumer can consume (in total quantity), the higher level of utility will be achieved, see figure 3.
Perfect substitutes have a linear utility function and a constant marginal rate of substitution, see figure 3. If goods X and Y are perfect substitutes, any different consumption bundle will result in the consumer obtaining the same utility level for all the points on the indifference curve (utility function). Let a consumption bundle be represented by (X,Y), then, a consumer of perfect substitutes would receive the same level of utility from (20,10) or (30,0).
Consumers of perfect substitutes base their rational decision-making process on prices only. Evidently, the consumer will choose the cheapest bundle to maximise their profits.
An example of perfect substitutes is butter from two different producers; the producer may be different but their purpose and usage are the same.
Perfect substitutes have a high cross-elasticity of demand. For example, if Country Crock and Imperial margarine have the same price listed for the same amount of spread, but one brand increases its price, its sales will fall by a certain amount. In response, the other brand's sales will increase by the same amount.
Imperfect substitutes
thumb|228x228px|Figure 4: Comparison of indifference curves of perfect and imperfect substitutes
Imperfect substitutes, also known as close substitutes, have a lesser level of substitutability, and therefore exhibit variable marginal rates of substitution along the consumer indifference curve. The consumption points on the curve offer the same level of utility as before, but compensation depends on the starting point of the substitution. Unlike perfect substitutes (see figure 4), the indifference curves of imperfect substitutes are not linear and the marginal rate of substitution is different for different set of combinations on the curve. Close substitute goods are similar products that target the same customer groups and satisfy the same needs, but have slight differences in characteristics.
Goods <math>x_i</math> and <math>x_j</math> are said to be net substitutes if
:<math>
\left.\frac{\partial x_j}{\partial p_i}\right|_{u=const}>0
</math>
That is, goods are net substitutes if they are substitutes for each other under a constant utility function. Net substitutability has the desirable property that, unlike gross substitutability, it is symmetric:
:<math>
\left.\frac{\partial x_j}{\partial p_i}\right|_{u=const} = \left.\frac{\partial x_i}{\partial p_j}\right|_{u=const}
</math>
That is, if good <math>x_j</math> is a net substitute for good <math>x_i</math>, then good <math>x_i</math> is also a net substitute for good <math>x_j</math>. The symmetry of net substitution is both intuitively appealing and theoretically useful.
The common misconception is that competitive equilibrium is non-existent when it comes to products that are net substitutes. Like most times when products are gross substitutes, they will also likely be net substitutes, hence most gross substitute preferences supporting a competitive equilibrium also serve as examples of net substitutes doing the same. This misconception can be further clarified by looking at the nature of net substitutes which exists in a purely hypothetical situation where a fictitious entity interferes to shut down the income effect and maintain a constant utility function. This defeats the point of a competitive equilibrium, where no such intervention takes place. The equilibrium is decentralized and left to the producers and consumers to determine and arrive at an equilibrium price.
Within-category and cross-category substitutes
Within-category substitutes are goods that are members of the same taxonomic category such as goods sharing common attributes (e.g., chocolate, chairs, station wagons).
Cross-category substitutes are goods that are members of different taxonomic categories but can satisfy the same goal. A person who wants chocolate but cannot acquire it, for example, might instead buy ice cream to satisfy the goal of having a dessert.
Whether goods are cross-category or within-category substitutes influences the utility derived by consumers. In the case of food, people exhibit a strong preference for within-category substitutes over cross-category substitutes, despite cross-category substitutes being more effective at satisfying customers' needs. Across ten sets of different foods, 79.7% of research participants believed that a within-category substitute would better satisfy their craving for a food they could not have than a cross-category substitute. Unable to acquire a desired Godiva chocolate, for instance, a majority reported that they would prefer to eat a store-brand chocolate (a within-category substitute) than a chocolate-chip granola bar (a cross-category substitute). This preference for within-category food substitutes appears, however, to be misguided. Because within-category food substitutes are more similar to the missing food, their inferiority to it is more noticeable. This creates a negative contrast effect, and leads within-category substitutes to be less satisfying substitutes than cross-category substitutes unless the quality is comparable. Unit-demand goods are always substitutes.
In perfect and monopolistic market structures
Perfect competition
Perfect competition is solely based on firms having equal conditions and the continuous pursuit of these conditions, regardless of the market size One of the requirements for perfect competition is that the goods of competing firms should be perfect substitutes. Products sold by different firms have minimal differences in capabilities, features, and pricing. Thus, buyers cannot distinguish between products based on physical attributes or intangible value. When this condition is not satisfied, the market is characterized by product differentiation. A perfectly competitive market is a theoretical benchmark and does not exist in reality. However, perfect substitutability is significant in the era of deregulation because there are usually several competing providers (e.g., electricity suppliers) selling the same good which result in aggressive price competition.
Monopolistic competition
Monopolistic competition characterizes an industry in which many firms offer products or services that are close, but not perfect substitutes. Monopolistic firms have little power to set curtail supply or raise prices to increase profits. Thus, the firms will try to differentiate their product through branding and marketing to capture above market returns. Some common examples of monopolistic industries include gasoline, milk, Internet connectivity (ISP services), electricity, telephony, and airline tickets. Since firms offer similar products, demand is highly elastic in monopolistic competition. As a result of demand being very responsive to price changes, consumers will switch to the cheapest alternative as a result of price increases. This is known as switching costs, or essentially what the consumers are willing to give up.
Market effects
The Michael Porter invented "Porter's Five Forces" to analyse an industry's attractiveness and likely profitability. Alongside competitive rivalry, buyer power, supplier power and threat of new entry, Porter identifies the threat of substitution as one of the five important industry forces. The threat of substitution refers to the likelihood of customers finding alternative products to purchase. When close substitutes are available, customers can easily and quickly forgo buying a company's product by finding other alternatives. This can weaken a company's power which threatens long-term profitability. The risk of substitution can be considered high when:
- Customers have slight switching costs between two available substitutes.
- The quality and performance offered by a close substitute are of a higher standard.
- Customers of a product have low loyalty towards the brand or product, hence being more sensitive to price changes.
Additionally substitute goods have a large impact on markets, consumer and sellers through the following factors:
- Markets characterised by close/perfect substitute goods experience great volatility in prices. This volatility negatively impacts producers' profits, as it is possible to earn higher profits in markets with fewer substitute products. That is, perfect substitute results in profits being driven down to zero as seen in perfectly competitive markets equilibrium.
- As a result of the intense competition caused the availability of substitute goods, low quality products can arise. Since prices are reduced to capture a larger share of the market, firms try to reduce their utilisation of resources which in turn will reduce their costs.