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Substitute Goods Definition
A substitute good is a product that can be used as a replacement for another product because it serves the same purpose. If the price of one product goes up, people may choose to buy the substitute instead, which can lead to a decrease in demand for the original product.
A substitute good is a product that can be used as an alternative to another product, with both products serving similar functions and having similar uses.
Let's say you love drinking coffee, but the price of coffee beans suddenly goes up due to a poor harvest. As a result, you may choose to buy tea instead, as it can provide a similar caffeine boost at a lower cost. In this scenario, tea is a substitute good for coffee, and as more people switch to tea, the demand for coffee will decrease.
Direct and Indirect Substitute Goods
Direct and indirect substitutes are types of substitute goods. A direct substitute is a product that can be used the same way as another product, while an indirect substitute is a product that can be used for the same general purpose but not the same way as the other product.
A direct substitute good is a product that can be used in the exact same way as another product.
An indirect substitute good is a product that can be used as an alternative to another product but not in the same way.
For example, butter and margarine are direct substitutes because they can both be used as spreads on toast or in cooking. On the other hand, visiting a cinema and attending a theatre are considered indirect substitutes since they share a common goal of providing entertainment in two distinctive ways.
Demand Curve for Substitute Goods Graph
The demand curve for substitute goods (Figure 2) is a useful tool for understanding how changes in the price of one product can affect the demand for a substitute product. This graph plots the relationship between the price of one product (good A) and the quantity demanded of another product (good B), which is a substitute for the first product.
The graph indicates that as the price of good A increases, the demand for substitute good B will also increase. This is because consumers will switch to the substitute good as it becomes a more attractive and affordable option. As a result, the demand curve for substitute goods has a positive slope, reflecting the substitution effect that occurs when consumers are faced with a product's price change.
Fig. 2 - Graph for substitute goods
Note that we assume that the price of the other good (Good B) remains constant while the price of the main good (Good A) changes.
Cross Price Elasticity of Substitute Goods
Cross price elasticity of substitute goods helps to measure the responsiveness of demand for one product to changes in the price of another product that can be used as a substitute. In other words, it measures the degree to which a change in the price of one product affects the demand for a substitute product.
The cross price elasticity of substitute goods is calculated by dividing the percentage change in the quantity demanded of one product by the percentage change in the price of another product.
\(Cross\ Price\ Elasticity\ of\ Demand=\frac{\%\Delta Q_D\ Good A}{\%\Delta P\ Good\ B}\)
Where ΔQD represents change in quantity demanded and ΔP represents change in price.
- If the cross price elasticity is positive, it indicates that the two products are substitutes, and an increase in the price of one will lead to an increase in the demand for the other.
- If the cross price elasticity is negative, it indicates that the two products are complements, and an increase in the price of one will lead to a decrease in the demand for the other.
For example, let's say that the price of coffee increases by 10%, and as a result, the demand for tea increases by 5%.
\(Cross\ Price\ Elasticity\ of\ Demand =\frac{10\%}{5\%}=0.5\)
The cross price elasticity of tea with respect to coffee would be 0.5, indicating that tea is a substitute for coffee, and consumers are willing to switch to tea when the price of coffee increases.
Substitute Goods Examples
Some examples of substitute goods include
Coffee and tea
Butter and margarine
Coca-Cola and Pepsi:
Nike and Adidas sneakers:
Cinemas and streaming services
Now, let's calculate cross price elasticity of demand to check if the good is a substitute or a complement.
A 30% increase in the price of honey causes a 20% increase in the quantity demanded of sugar. What is the cross price elasticity of demand for honey and sugar, and determine whether they are substitutes or complements?
Solution:
Using:
\(Cross\ Price\ Elasticity\ of\ Demand=\frac{\%\Delta Q_D\ Good A}{\%\Delta P\ Good\ B}\)
We have:
\(Cross\ Price\ Elasticity\ of\ Demand=\frac{20%}{30%}\)
\(Cross\ Price\ Elasticity\ of\ Demand=0.67\)
A positive cross-price elasticity of demand indicates that honey and sugar are substitute goods.
Substitute Goods - Key takeaways
- Substitute goods are products that serve similar purposes and can be used as replacements for each other.
- When the price of one product goes up, people may choose to buy the substitute instead, which leads to a decrease in demand for the original product.
- The demand curve for substitute goods has a positive slope, indicating that as the price of one product increases, the demand for the substitute product will also increase.
- Direct substitutes are products that can be used the same way as another product, while indirect substitutes are products that can be used for the same general purpose but not the same way as the other product.
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Frequently Asked Questions about Substitute Goods
What's the difference between substitute and complementary goods?
Substitute goods are products that can be used as alternatives to each other, while complementary goods are products that are used together.
What is a substitute good?
Substitute goods is a product that serves a similar purpose and can be used as replacements for the original product.
How to tell if goods are substitutes or complements?
Goods are substitutes if an increase in the price of one leads to an increase in the demand for the other, while they are complements if an increase in the price of one leads to a decrease in the demand for the other.
Yes, alternative modes of transport can be considered substitute goods as they serve a similar function and can be used interchangeably to meet the same need of transportation.
How does a price change of substitute goods affect demand?
As the price of one substitute good increases, the demand for the other substitute good(s) will increase as consumers switch to the relatively more affordable option.
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