Substitute good

In economics, one way we classify goods (two or more) is by examining the relationship of the demand schedules when the price of one good changes. This relationship between demand schedules leads economists to classify goods as either substitutes or complements. Substitute goods are goods which, as a result of changed conditions, may replace each other in use (or consumption)^[1]. A substitute good, in contrast to a complementary good, is a good with a positive cross elasticity of demand. This means a good's demand is increased when the price of another good is increased. Conversely, the demand for a good is decreased when the price of another good is decreased. If goods A and B are substitutes, an increase in the price of A will result in a leftward movement along the demand curve of A and cause the demand curve for B to shift out. A decrease in the price of A will result in a rightward movement along the demand curve of A and cause the demand curve for B to shift in.

Examples

Classic examples of substitute goods include margarine and butter, tea and coffee. Substitute goods not only occur on the consumer side of the market but also the producer side. Substitutable producer goods would include: petroleum and natural gas (used for heating or electricity). The degree to which a good has a perfect substitute depends on how specifically the good is defined. Take for example, the demand for Rice Krispies cereal, which is a very narrowly defined good as compared to the demand for cereal generally. The fact that one good is substitutable for another has immediate economic consequences: insofar as one good can be substituted for another, the demand for the two kinds of good will be bound together by the fact that customers can trade off one good for the other if it becomes advantageous to do so.

Increase in price

An increase in price (ceteris paribus) will result in an increase in demand for its substitutes goods. Thus, economists can predict that a spike in the cost of wood for the building industry will likely mean increased business for bricklayers, or that falling cellular phone rates will mean a decrease in business for public pay phones.

Different types

It is important to note that when speaking about substitute goods we are speaking about two different kinds of goods; so the "substitutability" of one good for another is always a matter of degree. One good is a perfect substitute for another only if it can be used in exactly the same way. In that case the utility of a combination is an increasing function of the sum of the two amounts, and theoretically, in the case of a price difference, there would be no demand for the more expensive good.

In microeconomics, two types of substitutes are being distinguished, , gross substitutes and net substitutes. Good $X_{i}$ is said to be gross substitute of good $Y$ if

{\frac {\partial X_{i}}{\partial P_{Y}}}>0

Goods X and Y are said to be net substitutes if

\left.{\frac {\partial X_{i}}{\partial P_{Y}}}\right|_{U=const}>0

where $U=U(X,Y)$ is a utility function for the two goods^[2].

Perfect and Imperfect substitutes

Indifference curve for perfect substitutes

Perfect substitutes may alternatively be characterized as goods having a constant marginal rate of substitution ^[3]. In this case, goods X and Y can be consumed in different quantitative proportions, but the consumer obtains the same level of utility along all points of the indifference curve. Alternative types of soft drinks are commonly used as an example of perfect substitutes. As the price of Coca Cola rises, consumers would be expected to substitute Pepsi in equal quantities, i.e., total cola consumption would hold constant. Also, blank media such as a writable Compact Discs from alternate manufacturers would be perfect substitutes. If one manufacturer raises the price of its CDs, consumers would be expected to switch to a lower cost manufacturer.

Imperfect substitutes 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 the compensation now depends on the starting point of the substitution.

Perfect Competition

One of the requirements for perfect competition is that the products of competing firms should be perfect substitutes. When this condition is not satisfied, the market is characterized by product differentiation.

Good Substitution

Substitute goods exhibit no complementarities, as in a complementary good.

In other words, good substitution is an economic concept where two goods are of comparable value. Potatoes from different farms are an example; if the price one farm's potatoes goes up, people will stop buying them and buy the other farm's instead, ceteris paribus (assuming that potatoes from different farms are homogenous)