Economic Definition of Substitute

The art of economics lies in the ability to accurately predict the interactions and relationships between various goods and industries within a marketplace. Just as in so many other disciplines, it is accepted that in economics there is a reaction for every action. This has led to a number of laws and definitions which are always true in certain isolated situations. With the concept of substitute goods, it is assumed that there are two goods in the marketplace that are seen as equal in value in every way, and that consumers will readily accept whichever is most available. This leads to a set of predictable interactions that, if all of the parameters in the definition of a substitute are met, are always true.

What is a substitute?

Essentially, a substitute good is one that is perfectly equal to another, or that consumers would just as readily accept to perform the same function. An example would be that if someone thinks Jiffy peanut butter and Skippy peanut butter taste alike, then those products are substitutes for each other in that consumer's mind. If this is true on a large scale, then you can expect substitute interaction patterns to emerge between the two products.

Substitute effects on buying patterns

Having a perfect substitute means that a change in price in one product directly affects the purchasing of the other. That is to say that if one product raises its prices, then it will see a decrease in sales that is equal to an increase that its perfect substitute will experience. Conversely, if one product lowers their price, then it will experience an increase in sales that is equal to the decrease in the product that is now more expensive.

Pricing of products that have substitutes

Because of the fact that price changes in one product will result in changing purchase patterns in its substitute, they can also affect each other's prices. For example, if one product's price goes down, it is quite predictable that the substitute product will not want their sales to decrease. As a result, they are likely to lower their price in order to keep pace with the comparable product. On the other hand, neither manufacturer wants to trigger any kind of price war, so they are far less likely to change their prices at all unless they have to. This often keeps prices fairer for the consumer, with raises reflecting actual increases in the cost of production that are likely to afflict both companies. This can backfire for the consumer as well, especially in a small market. Situations like this are how oligopolies are born, with manufacturers of similar products working in concert to maximize their profits for both companies by raising prices in cooperation with each other.

How companies try to eliminate perfect substitutes

In real-world markets, it is very difficult to find products that are perfect substitutes for each other. This is because every company assesses their competition, and tries to find some point of differentiation off of which they can work in their marketing. This may mean simply extoling a virtue that both products have, but only one brand is bringing to the attention of the public. It could be a difference in marketing focus and demographic appeal, or a difference in marketing budget and expertise. In addition, many manufacturers create packages of products that offer value or convenience, and thereby make their product different in the eyes of the consumer.

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