Substitute good
[2] 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 soft drink.
Economic theory describes two goods as being close substitutes if three conditions hold:[3] Performance characteristics describe what the product does for the customer; a solution to customers' needs or wants.
[3] For example, orange juice and soft drinks are both beverages but are used by consumers in different occasions (i.e. breakfast vs during the day).
[3] Only if the two products satisfy the three conditions, will they be classified as close substitutes according to economic theory.
These two goods satisfy the three conditions: tea and coffee have similar performance characteristics (they quench a thirst), they both have similar occasions for use (in the morning) and both are usually sold in the same geographic area (consumers can buy both at their local supermarket).
Some other common examples include margarine and butter, and McDonald's and Burger King.
Cross-price elasticity helps us understand the degree of substitutability of the two products.
[4] The relationship between demand schedules determines whether goods are classified as substitutes or complements.
[8] 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.
As the price of Coca-Cola rises, consumers could be expected to substitute to Pepsi.
[11] The common misconception is that competitive equilibrium is non-existent when it comes to products that are net substitutes.
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.
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.
[13] Whether goods are cross-category or within-category substitutes influences the utility derived by consumers.
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).
For example, consider a consumer that wants a means of transportation, which may be either a car or a bicycle.
The economic theory of unit elastic demand illustrates the inverse relationship between price and quantity.
Thus, buyers cannot distinguish between products based on physical attributes or intangible value.
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 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.
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.
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.
