How substitute and complementary of goods influence demand of a consumer explain?

Demand elasticity measures how sensitive demand for a good or service is to changes in other variables. There are, in fact, many factors that are important in determining the demand elasticity for a good or service, such as the price level, the type of good or service, the availability of a substitute, and levels of consumer incomes.

Key Takeaways

• Many factors determine the demand elasticity for a product, including price levels, the type of product or service, income levels, and the availability of any potential substitutes.
• High-priced products often are highly elastic because, if prices fall, consumers are likely to buy at a lower price.
• Compared to essential goods, luxury items are highly elastic.
• Goods with many alternatives or competitors are elastic because, as the price of the good rises, consumers shift purchases to substitute items.
• Incomes and elasticity are related—as consumer incomes increase, demand for products increases as well.

Price Levels

The price level of an item affects the demand for a good or service, and the price elasticity of demand can be used to measure the sensitivity of a change in the quantity demanded of a good or service relative to a change in price. The price elasticity of demand is calculated by dividing the percent change in the quantity demanded of a good or service by its percent change in its price level.

For example, luxury goods have a high price elasticity of demand because they are sensitive to price changes. Suppose the prices of LED televisions decrease in price by 50%. The demand increases because they are more affordable to those who were unable to purchase them before.

The type of good or service affects the elasticity of demand as well. A good or service may be a luxury item, a necessity, or a comfort to a consumer. When a good or service is a luxury or a comfort good, the demand is highly price-elastic when compared to a necessary good. Conversely, the demand for an essential good, such as food, is generally price-inelastic because consumers still buy food even if the price changes.

Incomes and Alternatives

The availability of alternatives or substitute goods can affect demand elasticity. Hence, the demand for goods or services with many substitutes is highly price elastic; a small increase in the price levels of goods causes consumers to buy its substitutes. For example, the demand for soda is highly price-elastic because of a large number of substitutes. If the price of one soda rises, consumers can opt to buy the cheaper substitute.

When close substitutes are available, the quantity demanded is highly sensitive to changes in the price level and vice versa. The demand elasticity of goods with close substitutes is measured by dividing the percent change of the quantity demanded of one product by the percent change in the price of a substitute product. This formula is also known as the cross elasticity of demand.

Lastly, the level of consumer income plays a role in the demand elasticity of goods and services. The income elasticity of demand is used to measure the sensitivity of a change in the quantity demanded relative to a change in consumers' incomes. Different types of goods are affected by income levels. For example, inferior goods, such as generic products, have a negative income elasticity of demand because the quantity demanded for generic products tends to fall as consumers' incomes increase.

What Is a Substitute?

A substitute, or substitutable good, in economics and consumer theory refers to a product or service that consumers see as essentially the same or similar-enough to another product. Put simply, a substitute is a good that can be used in place of another.

Substitutes play an important part in the marketplace and are considered a benefit for consumers. They provide more choices for consumers, who are then better able to satisfy their needs. Bills of materials often include alternate parts that can replace the standard part if it's destroyed.

Key Takeaways

• A substitute is a product or service that can be easily replaced with another by consumers.
• In economics, products are often substitutes if the demand for one product increases when the price of the other goes up.
• Substitutes provide choices and alternatives for consumers while creating competition and lower prices in the marketplace.

What are Substitute Goods?

Understanding Substitutes

When consumers make buying decisions, substitutes provide them with alternatives. Substitutes occur when there are at least two products that can be used for the same purpose, such as an iPhone vs. an Android phone. For a product to be a substitute for another, it must share a particular relationship with that good. Those relationships can be close, like one brand of coffee with another, or somewhat further apart, such as coffee and tea.

Giving consumers more choice helps generate competition in the market and lower prices as a result. While that may be good for consumers, it may have the opposite effect on companies' bottom line. Alternative products can cut into companies' profitability, as consumers may end up choosing one more over another or see market share diluted.

When you examine the relationship between the demand schedules of substitute products, if the price of a product goes up the demand for a substitute will tend to increase. This is because people will prefer to lower-cost substitute to the higher cost one. If, for example, the price of coffee increases, the demand for tea may also increase as consumers switch from coffee to tea to maintain their budgets.

Conversely, when a good's price decreases, the demand for its substitute may also decrease. In formal economic language, X and Y are substitutes if demand for X increases when the price of Y increases, or if there is positive cross elasticity of demand.

The availability of substitutes are one of Porter's 5 Forces, the others being competition, new entrants into the industry, the power of suppliers, and the power of customers.

Examples of Substitute Goods

Substitute goods are all around us. As mentioned above, they are generally used for the same purpose or are able to satisfy similar needs for consumers.

Here are just a few examples of substitute goods:

• Currency: a dollar bill for 4 quarters (also known as fungibility)
• Coke vs. Pepsi
• Premium vs. regular gasoline
• Butter and margarine
• Tea and coffee
• Apples and oranges
• Riding a bike versus driving a car
• E-books and regular books

There is one thing to keep in mind when it comes to substitutes: the degree to which a good is a substitute for another can, and often will, differ.

Perfect vs. Less Perfect Substitutes

Classifying a product or service as a substitute is not always straightforward. There are different degrees to which products or services can be defined as substitutes. A substitute can be perfect or imperfect depending on whether the substitute completely or partially satisfies the consumer.

A perfect substitute can be used in exactly the same way as the good or service it replaces. This is where the utility of the product or service is pretty much identical. For example, a one-dollar bill is a perfect substitute for another dollar bill. And butter from two different producers are also considered perfect substitutes; the producer may be different, but their purpose and usage are the same.

A bike and a car are far from perfect substitutes, but they are similar enough for people to use them to get from point A to point B. There is also some measurable relationship in the demand schedule.

Although an imperfect substitute may be replaceable, it may have a degree of difference that can be easily perceived by consumers. So some consumers may choose to stick with one product over the other. Consider Coke versus Pepsi. A consumer may choose Coke over Pepsi—perhaps because of taste—even if the price of Coke goes up. If a consumer perceives a difference between soda brands, she may see Pepsi as an imperfect substitute for Coke, even if economists consider them perfect substitutes.

Less perfect substitutes are sometimes classified as gross substitutes or net substitutes byfactoring in utility. A gross substitute is one in which demand for X increases when the price of Y increases. Net substitutes are those in which demand for X increases when the price of Y increases and the utility derived from the substitute remains constant.

Substitute Goods in Perfect Competition and Monopolistic Competition

In cases of perfect competition, perfect substitutes are sometimes conceived as nearly indistinguishable goods being sold by different firms. For example, gasoline from a gas station on one corner may be virtually indistinguishable from gasoline sold by another gas station on the opposite corner. An increase in the price at one station will result in more people choosing the cheaper option.

Monopolistic competition presents an interesting case that present complications with the concept of substitutes. In monopolistic competition, companies are not price-takers, meaning demand is not highly sensitive to price. A common example is a difference between the store brand and name-branded medicine at your local pharmacy. The products themselves are nearly indistinguishable chemically, but they are not perfect substitutes due to the utility consumers may get—or believe they get—from purchasing a brand name over a generic drug believing it to be more reputable or of higher quality.

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