In microeconomics, substitute goods are two goods that can be used for the same purpose by consumers. That is, a consumer perceives both goods as similar or comparable, so that having more of one good causes the consumer to desire less of the other good. Contrary to complementary goods and independent goods, substitute goods may replace each other in use due to changing economic conditions. An example of substitute goods is Coca-Cola and Pepsi; the interchangeable aspect of these goods is due to the similarity of the purpose they serve, i.e. fulfilling customers' desire for a cola-flavored soft drink. These types of substitutes can be referred to as close substitutes. Economic theory describes two goods as being close substitutes if all three following conditions hold:
products have the same or similar performance characteristics products have the same or similar occasion for use products are sold in the same geographic area
Performance characteristics describe what the product does for the customer; a solution to customers' needs or wants. For example, a beverage would quench a customer's thirst. A product's occasion for use describes when, where and how it is used. For example, orange juice and soft drinks are both beverages but are used by consumers in different occasions (i.e. breakfast vs during the day). Two products are in different geographic market if they are sold in different locations, it is costly to transport the goods or it is costly for consumers to travel to buy the goods. Only if the two products satisfy the three conditions, will they be classified as close substitutes according to economic theory. An example of substitute goods are tea and coffee. These two goods satisfy the three conditions: tea and coffee have similar performance characteristics (they quench a thirst), they both have similar occasions for use (in the morning) and both are usually sold in the same geographic area (consumers can buy both at their local supermarket). Some other common examples include margarine and butter, and McDonald's and Burger King. The opposite of a substitute good is a complementary good, i.e. goods that are dependent on another. An example of complementary goods are cereal and milk. Formally, good x j {\displaystyle x_{j}} is a substitute for good x i {\displaystyle x_{i}} if when the price of x i {\displaystyle x_{i}} rises the demand for x j {\displaystyle x_{j}} rises, see figure 1. Let p i {\displaystyle p_{i}} be the price of good x i {\displaystyle x_{i}} . Then, x j {\displaystyle x_{j}} is a substitute for x i {\displaystyle x_{i}} if: ∂ x j ∂ p i > 0 {\displaystyle {\frac {\partial x_{j}}{\partial p_{i}}}>0} .
Cross elasticity of demand The fact that one good is substitutable for another has immediate economic consequences: insofar as one good can be substituted for another, the demands for the two goods will be interrelated by the fact that customers can trade off one good for the other if it becomes advantageous to do so. Cross-elasticity helps us understand the degree of substitutability of the two products. An increase in the price of a good will increase demand for its substitutes, while a decrease in the price of a good will decrease demand for its substitutes, see Figure 2.
The relationship between demand schedules determines whether goods are classified as substitutes or complements. The cross-elasticity of demand shows the relationship between two goods, it captures the responsiveness of the quantity demanded of one good to a change in price of another good.
Cross-elasticity of demand ( XED {\displaystyle {\text{XED}}} ) is calculated with the following formula:
XED = % change in quantity demanded of good A % change in price of good B {\displaystyle {\text{XED}}={\frac {\%{\text{ change in quantity demanded of good A}}}{\%{\text{ change in price of good B}}}}}
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