EFFECT OF PRICE

CHANGE ON
SUBSTITUTE GOODS
BY DRISHIKA MAHAJAN
11 C

KEYWORDS - substitute goods, indifference curve, perfect substitute , imperfect substitutes,

market demand
INTRODUCTION

Those goods that can be in place of one another to satisfy a specific need or a want. They have a
competitive demand. Take in consideration two modes of travel busses and train if the price of
train tickets increase by a significant amount the demand for bus tickets will increase because
people may prefer to use a cheaper mode of transportation

In microeconomics, two goods are substitutes if the products could be used for the same
purpose by the 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.
Substitutes play a vital role in the market. They provide choices to the consumer who are then
able to satisfy their want

DEFINITION

Economic theory describes two goods as being close substitutes if three conditions are satisfied,
products have the same or similar performance characteristics, products have the same or
similar occasion for use and products are sold in the same geographic area.

Performance characteristics describe what the product does for the customer or how the
product helps the customer. For example a food item like a burger satisfies the hunger of a
customer. 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
Geographical area - Two products are in different geographic markets. If they are sold in
different locations, the cost of transport will play a major role here. For example - product A
costs rupees 200 and product B costs rupees 150 but B is 30 minutes away from your house
whereas A is only 10 minutes away. You may prefer to buy product A even though it costs more.

Cross elasticity of demand

Since substitute goods can be used instead of each other, the demand for the two goods is also
interrelated. If the price of one of the products rises the demand for its substitute will increase
and if the price of a good falls the demand for its substitute will also decrease. Cross elasticity
measures the percentage change in quantity demanded for good A to the percentage change in
price for good B. It helps us determine the relationship between two goods, if they are
complementary, supplementary or independent. A positive cross elasticity denotes two
products are substitutes of each other.
Two goods that are substitutes have a positive cross elasticity of demand: as the price of good Y
rises, the demand for good X rises

Suppose the price of good A rises from P1 to P2. This would cause the consumer to consume
less of good A, decreasing the quantity demanded from Q1 to Q2. This would cause a rightward
movement of the demand curve. The demand curve for good B will move from D to D’ ,ie, at
the same price the quantity demanded for good B will increase.
Suppose the price of good A falls from P1 to P2. The consumer would now consume more of
good A, increasing quantity demanded from Q1 to Q2. the consumer would now consume less
of good B causing a leftward shift in the demand curve for good B. the demand curve for good
B will move from D to D’.

TYPES OF SUBSTITUTE GOODS

Perfect substitute

Perfect Substitute Goods are those goods that can satisfy the same necessity in exactly the same
way. A substitute good can be used in place of another. If the consumer can choose between
buying one substitute good or another, she will buy the cheaper one. A one-dollar bill is a
perfect substitute for another one-dollar bill. Commodities: rice of the same quality Electricity
from different power plants. A person cannot differentiate from which power plant the
electricity she uses comes from. Very similar goods from different providers. For example,
compact disks (CDs) from different providers.

Indifference curve of perfect substitute

An indifference curve, with respect to two commodities, is a graph showing those combinations
of the two commodities that leave the consumer equally well off or equally satisfied. It shows
the combination of two goods that gives a consumer equal utility
If a consumer uses 1 less unit of a good they will have to consume 1 more unit of its perfect
substitute to maintain equilibrium, thus we can say the indifference curve of perfect substitute is
a straight line at 45 degree angle.

Perfect substitutes have a constant marginal rate of substitution ( rate at which consumer can
give up one item to have more of the other item ) and a linear utility function
When the consumer is willing to substitute goods in a 1 to 1 ratio. Consumer now only cares
about the total quantity she has of good 1 and good 2 and not about weather this quantity is
composed more of good 1 or good 2

From the utility function (1) U = x + y we extract:

y = U - x (6)
Fixing the utility level, we can plot the indifference curve:

Figure 3: Indifference Curves of Perfect Substitute Goods

The marginal rate of substitution is the rate at which consumers can give up an amount in
exchange for another good to maintain the same level of utility. The MRS of one good is the
slope of the indifference curve. Perfect substitutes have a constant marginal rate of
substitution.The value of this slope is throughout minus 1, and MRSXY = 1.

Consumers of perfect substitutes base their rational decision making process on prices only.
Evidently, the consumer will choose the cheapest bundle. If the prices of the goods differed, there
would be no demand for the more expensive goods. Producers and sellers of perfect substitute
goods directly compete with each other, that is, they are known to be in direct price competition

Imperfect substitute

Imperfect substitutes, also known as close substitutes, have a lesser level of substitutability.
They are similar products that target the same customer groups and satisfy the same needs, but
have slight differences in characteristics.

The indifference curves of imperfect substitutes are not linear and the marginal rate of
substitution is different for different sets of combinations on the curve.Close substitute goods
are similar products that target the same customer groups and satisfy the same needs, but have
slight differences in characteristics.

As the price of good A rises, consumers could be expected to substitute good B. However, many
consumers prefer one brand over the other. Consumers who prefer good A over the other will
not trade between them one-to-one. Rather, a consumer who prefers A will be willing to
exchange more good B for less of good A.

In the graph given above the consumer is willing to buy 1 unit of food for 12 units of clothing.

IN A PERFECT AND IMPERFECT MARKET STRUCTURE

Perfect competition

When two companies sell two products that are perfect substitutes they are said to be in perfect
competition. The quality, characters and price of products are very similar. The consumer cannot
distinguish between these two products based on a single characteristic. When the buyers are
unable to distinguish between two products the market is characterised by product
differentiation,ie, the two companies will use various methods and strategies to make their
product stand out.

imperfect competition

Imperfect competition is a competitive market situation where there are many sellers, but they
are selling heterogeneous (dissimilar) goods as opposed to the perfect competitive market
scenario. As the name suggests, competitive markets that are imperfect in nature.
MARKET EFFECT

The threat of substitution is a very important factor which determines the profit margin of a
product. It refers to the likelihood of people finding and alternate / substitute products in the
market thereby giving an option to choose the product to the consumer. Substitutes whether
perfect or imperfect give an option to the consumers to choose the best option as per their
needs. They can easily and quickly forgo buying a particular product upon finding suitable
alternatives this threatens a particular product and its profitability in the long term

Risk of substitution can be considered high when: the cost of the substitutes are comparable, the
utility and quality is similar and customers are not loyal to a brand. Therefore from this we can
conclude that for perfect substitutes the risk of substitution is very high and for imperfect
substitutes it is relatively low

When the market has perfect substitutes the price of the substitute changes rapidly. This benefits
the consumer but has a negative impact on profits. Perfect substitutes can result in profit being
nearly 0. However another factor which is not in the interest of consumer is that a low quality
perfect substitute can sell at a higher price

imperfect substitutes give an option of a wide range of products to the consumer. Evry
consumer selects what is right for them. As a result, every consumer reaches a higher overall
utility level from the available substitute

Case study

A case study on the price war of two substitute products pepsi and coke way back in the year
2003 is shown below. In those days both these soft drinks were available in 200ml, 300ml and
500ml bottles.

In april 2003 pepsi slashed the price of its 300 ml returnable glass bottle from Rs 8 to Rs 6 in
order to make its brand more affordable. Coca Cola, while continuing to maintain its 300ml
bottle at Rs 8 attempted to counter this and win the market share by introducing a 600 ml bottle
at Rs 12 while Pepsi was selling 500ml bottle at Rs 15. Pepsi was forced to reduce the price of its
500ml bottle to match that of coke and retain its market share. Simultaneously Coke tried to
capture the market share of the 200ml bottle by offering sunfill sachets of Rs 2 free with 200ml
and 300ml bottles respectively while maintaining the original price of the two commodities. It
also slashed the price of its 1.5 and 2 litre bottles to capture its home/consumption segment
ANALYSIS - From the above paragraph we can conclude that Coca - Cola and Pessi are perfect
substitutes and hence the pricing strategy of one directly impacts the demand of the other.
Hence its indifference curve would be a straight line with equal slopes across all points on the
line.

Pepsi slashed the price of its 300ml bottle from Rs 8 to Rs 6 therefore anticipating an increase in
demand and consumption of its product. This can be shown by plotting the price elasticity of
demand for Pepsi. It reduced its price from P1 (Rs 8) to P2 (Rs 6 ) Which would result in
increased consumption from Q1 to Q2.

Since coke and pepsi are perfect substitutes, an increase in consumption of pepsi would result in
a proportional decrease in consumption of Coke. Therefore, not to lose out on the market share
Coke started giving sun-filled sachets priced at Rs 2 for free to increase the marginal utility on
its product. This would result in an increase in consumption of coke. As the Marginal Utility
moved from MU1 to MU2 because of the value addition so would its quantity from Q1 to Q2.
CONCLUSION - I chose to write about Effect of price change on substitute goods as this is a
very important theory and can also be seen in our day to day life. Many items in our daily life
are substitutes of each other, the different brands of erasers for pencils. We can conclude that the
price change in substitute goods affects how we choose to buy a product and how much we
buy to satisfy our needs. There are types of substitutes goods and these different types of
substitute goods have a different effect on the market demand. We can also say that companies
that produce perfect substitutes face fierce competition and constantly change strategies to gain
profit. Substitute goods affect our daily life and decisions.

BIBLIOGRAPHY

Source: https://economicpoint.com/perfect-substitute-goods
https://en.wikipedia.org/wiki/Substitute_good

https://html.rincondelvago.com/consumer-behaviour_1.html?url=consumer-behaviour_1

https://marketbusinessnews.com/financial-glossary/substitute-goods-definition-meaning/

https://economicpoint.com/perfect-substitute-goods

https://www.investopedia.com/terms/i/indifferencecurve.asp

https://www.economicsdiscussion.net/indifference-curves/substitutes-and-complements-in-in
difference-curve-analysis/18361

https://economictimes.indiatimes.com/definition/imperfect-competition