Substitute Goods: Definition, Types & Examples
What are Substitute Goods
A substitute good is not necessarily just a physical product – it can also be a service. In fact, it is defined as a product or service that is used in place of another. For example, when the price of McDonald’s increases, more customers may choose to go the Burger King, or KFC.
To put it another way – a substitute good is a similar product that can be used instead of another. In other words, it is similar enough to be used for the same function. For instance, both the iPhone and Galaxy Note are two substitutes as they both act as a mobile phone. So if you want a phone, they provide two different options.
- A substitute good is defined as a product or service that is used in place of another.
- When the price of one substitute good goes up, the demand for the other substitute also goes up – this is known as positive cross price elasticity.
- Substitute goods are highly competitive as they can be easily replaced by a competitor.
Substitute goods ensure there is a competitive environment. This is important because it helps keep prices down, and quality up. In simple terms, when the price of one good goes up, the demand for a substitute good will increase. So when McDonalds increases the price of their Big Mac from $9 to $15; customers will get a burger from Burger King for $9 instead.
Substitute Goods Examples
There are two types of substitute goods: indirect and direct. A direct substitute is whereby two products can be readily exchanged for one another. Think of Pepsi and Cola.
By contrast, an indirect substitute is where two goods can still be replaced by one another, but have a weak correlation. For example, bowling and dancing. Although the instructor may cancel the consumers dancing class, they may wish to entertain themselves with a game of bowling instead. The difference being is that the two are not commonly substituted for one another.
With that said, let us now look at some examples.
Direct Substitute Examples
- Pepsi and Coca-Cola
- McDonalds and Burger King
- Playstation and Xbox
- Supermarket-branded and Branded products
- Transport by Car or Train
- iPhone and Samsung Galaxy
- Pizza Hut and Domino’s
- Physical Books and Kindle
In-direct Substitute Examples
- Dancing and bowling
- Bowling and Video games
- Banana and Doughnuts
Direct Substitute Goods
Direct substitute goods are very similar and share a number of attributes. For example, Coca-Cola and Pepsi are direct substitutes within the market of soda. These are also referred to as ‘within-category substitutes’ or ‘close substitutes’.
“Direct Substitutes share many common characteristics, but most importantly, consumers readily switch between the two.”
Direct substitutes have what we call a high cross-elasticity of demand. To explain, this is whereby two products are easily exchangeable. For example, there may be a branded bag of flour and an own-branded one. Customers preference may be highly influenced by any changes in the variables; particularly price.
Direct substitute goods have a high cross-elasticity of demand. For instance, when the price of Coca-Cola goes up and its sales fall by 10 percent; the sales of Pepsi increase by close to 10 percent. In other words; if there is a high correlation between the two, then they can be considered direct substitute goods.
In-direct Substitute Goods
In-direct substitute goods may come from different industries or categories that are seemingly unrelated. For example, the price of bowling may go up, so customers buy more video games instead. They are different products and are from different industries, but a proportion of customers may readily substitute the two.
These have what we call a low cross-elasticity of demand. For example, a customer may go into the store for a doughnut, only to find there are none in stock. They may come out with a banana instead. Two completely unrelated items, but ones that can in fact be substituted.
In-direct substitutes are not too common, which is why they have a low cross-elasticity of demand. An increase in the price of bowling and a decline in sales of 10 percent may only increase video game sales by 1 percent. The relationship between the two is therefore weak. However, it is important for marketers to consider this.
Factors that affect Substitute Goods
As we can see from the illustration below; when McDonald’s increases its price, the demand for Burger King increases. However, price is not necessarily the sole variable when considering the power of substitution. There are many factors at play.
Substitute goods satisfy consumer wants when a variable changes. There are various factors at play such as price, quality, and geography. If one of these changes, substitute goods come into play.
You may buy a nice fresh doughnut every day from the local baker. However, one day the quality of these doughnuts declines. It is dry and has no flavour. Think of all the other things you may choose to substitute it. There may be other cakes, waffles, or something else. Anything else that is purchased instead of the doughnut can be considered as a substitute good.
Why Consumers Choose Substitutes
Consumers choose substitutes for a number of reasons. Let us look at some of them below:
Probably the most common reason customers substitute goods is the price. In a restaurant, a pint of Beer may be $10 and a Cola may be $3; the customer has to believe that the beer is worth $7 more to them. Each individual places a certain value on each product. So when deciding, the customer makes a decision based on their desire for one product over the other. These are decisions we have taken without thinking.
Often quantity/supply can affect consumers’ decisions to purchase substitute goods. For example, the last of the iced-ringed doughnuts may have been sold in the local grocery store. Customers may look for substitute goods instead.
The quality of the product can affect the demand for substitute goods. If a known product does not taste as good, last as long, or is comfortable, this can be considered during the decision process. There may be that run-down restaurant round the corner that produces food that is okay. However, the lower quality is considered alongside the pricing.
There may be two supermarkets. One that’s on the way home from work and another that is another 15 mins out of the way. The geographical location gives the customer convenience. When deciding upon a product, this is another variable that the customer will consider.
Consumer tastes can change over time. There may be a craze or a festive product that is only available at certain times of the year. For example, mince pies are only available at Christmas. This may be a substitute for other bakery goods, but the seasonality of the product gives it extra value to the customer.
On a micro basis, growth in income can have the effect of changing consumer behaviour. Rather than having a homemade coffee, consumers may grab one of the go from Starbucks. Alternatively, they may start buying more lean cuts of steak as their incomes increase. As incomes rise, the price of a good becomes less of a factor when considering substitute goods.
There are both indirect and direct substitute goods.
Direct examples include:
• Pepsi and Coca-Cola
• McDonalds and Burger King
• Playstation and Xbox
• Supermarket-branded and Branded products
• Transport by Car or Train
• iPhone and Samsung Galaxy
• Pizza Hut and Domino’s
• Physical Books and Kindle
Indirect examples include:
• Dancing and bowling
• Bowling and Video games
• Banana and Doughnuts
Substitute goods are two goods that can be used in place of one another, for example, Dominos and Pizza Hut. By contrast, complementary goods are those that are used with each other. For example, pancakes and maple syrup.
The key difference is that substitute goods replace one another, whilst complementary goods add value to the other.
A substitute good is not necessarily just a physical product; it can also be a service. Essentially, it is a product or service that is used in place of another.
Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.