Substitutes are those goods that serve the same purpose as the original and can be used as an alternative. On the other hand, complementary goods are two or more distinct items or goods whose use is associated or interrelated with each other.
Substitute goods have positive cross price elasticity, while complementary goods have negative cross price elasticity.
Economics classifies goods on the basis of various characteristics, viz., luxury goods, essential goods, substitute goods, Giffen goods, etc. These goods have various price elasticity demands. ‘Willingness to pay’ is a terminology that defines how much quantity a customer is willing to buy at a given price level.
Price elasticity measures the degree of variance in the quantity demanded, in response to the change in price of a product. Price elasticity of any product is influenced by many factors such as technology, fashion, industry, economic conditions of the nation, rate of inflation, resource availability, etc. Cross price elasticity measures the impact on the demand of a good in response to the change in price of any other good. This MarketingWit article talks in depth about the complementary and substitute goods, the difference between them, and their cross price elasticity.
What are Substitute Goods?
Substitute goods refer to alternative goods to any particular product, that can be used as a replacement for the original product or good. Thus, it implies that their price elasticity is interrelated.
Instead of a Coke, you can buy another aerated drink like Pepsi or RC Cola, i.e., they are substitutes for each other.
Price Elasticity of Substitute Goods
Price elasticity measures the degree of relativity of change in demand of a product in response to change in price of the product. Price elasticity of a substitute good is cross elastic, i.e., its demands and price are inversely proportional to each other. If a certain product enjoys monopoly in the market, it is less likely to have any substitutes. Thus, the degree of substitution may differ, too. These goods can be further classified into weak substitutes or perfect substitutes, i.e., those that are quite similar to each other.
Suppose ‘R’ and ‘S’ are substitute goods for each other. Price of ‘R’ increases, the demand for it will reduce. However, consumers will prefer to buy product ‘S’, hence, demand for ‘S’ will increase at the similar price level. This proves that there is an inverse relationship between demand of substitute goods.
Impact of Market Conditions on Substitute Goods
- The psychology of consumers keeps on changing according to fashion trends, technology, brand name, etc. For example, cotton was the reigning fabric till some time ago; however, with the advent of synthetic fibers, cotton took a back seat. These synthetic fibers are available at lower cost. Hence, the market for cotton was largely taken over by them. However, these substitutes cannot furnish the same comfort as cotton; hence, many do not prefer to use fabrics made of artificial fibers.
- Another powerful impact is that of fashion. Many consumers prefer to buy those products which their favorite celebrities endorse. Hence, demand for substitutes are also affected by other parameters.
- There are some consumers who are brand loyal, and will not like to experiment with other substitutes, even if the substitute is of the same or a higher quality. Again, degree of elasticity is impacted in this case.
What are Complementary Goods?
As the name suggests, complementary goods are those goods that are used along with each other, or the use of one product complements the another. There are many examples that can be cited from our daily lives. When they are used exclusively, they might have no value or lesser value than when used with each other.
Tires and cars, gaming consoles and video games, toothpaste and toothbrush. Since the use of both goods is directly proportional, they have negative cross elasticity of demand. When the price of one product increases, the demand for the complementary product decreases.
Substitute vs. Complementary Goods
Let’s consider an example to further illustrate the difference between these goods. Different brands of cars are substitute goods; on the other hand, a car and tire can be said to be complementary goods. The following graphs depicts the demand curve of substitute and complementary goods.
Let’s assume that the price of a car brand X has increased. Obviously, consumers will shift their preferences to alternative brands. A similar brand Y is available in the market, and consumers will prefer to buy it instead of brand X.
The above graph indicates the rise in the demand of brand Y. At the same price level of OP, there is an increase in quantity demanded from OQ to OQ1. The intersection of price and quantity shows the demand curves. Thus, D1D1 is the new demand curve.
This indicates that substitute goods have positive cross price elasticity.
Let’s assume that the price of the same car brand X has risen. The demand of that car brand will obviously reduce. However, along with the decrease in demand for the car, there will be automatically lesser demand for the tire used on the car.
The above graph depicts the demand curve of tires used in car brand X. Price of the tire is at the same level OP. However, with the increase in price of car brand X, lesser quantity is demanded of the tires, too. Hence the price level falls from OQ to OQ1. Accordingly, there is a downward shift in the demand curve from DD to D1D1.
Thus, the cross price elasticity is negative in this case.
As a consumer, we come across many such examples of substitute and complementary goods. Our preferences, psychology, and other factors also influence their demand, other than mere price changes.