Substitutes vs Complements

3 Key excerpts on "Substitutes vs Complements"

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  eBook - ePub

  Simplified Real-World Economics

  A Practical Guide for Managers and Small Business Owners

  • Michael Thomsett(Author)
  • 2020(Publication Date)
  • J. Ross Publishing

    (Publisher)

  A substitute is not always selected rationally or economically. Beyond obsolescence, substitutions may be bought based on many factors beyond price—and they may not all be rational. As a theory in economics, products may be substitutes based on many factors. The most often cited factor is similarity in price—but this is not always the case. A business owner might discover that some consumers will pay much more for a substitute based on reputation and brand, perceptions of higher quality, and other criteria. A substitute replaces another product, and the decision to pick the substitute might be the result of exceptional marketing, claims of higher quality (true or not), or superiority. This theory of substitution is usually simplified as a price analysis. As the price of one product rises, demand for a different product (the substitute) rises in response. However, substitutes often involve more than price.

  For example, consumers may purchase frozen food rather than fresh, even if the cost is much higher. This is a substitute of convenience. It is easier to prepare frozen food in a microwave oven and it only takes five or six minutes. Buying instant coffee costs about one-half compared to buying the beans and grinding them yourself. However, the second choice produces a superior cup of coffee in the opinion of many consumers. In that case, price does not matter, even a much higher price; what matters is quality in this form of substitution.

  Compared to substitutes, complements (or, complementary goods) lack elasticity of demand. The demand grows because the price of a similar product rises; consumers pick the complementary product based on price comparison, assuming both products provide the same benefits and are of comparable value and quality.4

  When the price of goods is increased, quantity tends to increase as well. Supply must be increased to meet higher demand. These relationships between price and quantity on one hand, and demand and supply in response, are shown in Figure 7.1 .

  Figure 7.1 Complements and the demand and supply curve

  This is where complements enter the picture. As an initial price rises and the producer offers more goods at the higher price, an opportunity arises for a competitor. By offering a complementary product at a lower price, the competing producer will be able to take greater market share from the initial producer.

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  eBook - ePub

  Economic Systems Analysis and Assessment

  Intensive Systems, Organizations,and Enterprises

  • Andrew P. Sage, William B. Rouse(Authors)
  • 2011(Publication Date)
  • Wiley-Interscience

    (Publisher)

  If commodities are substitutes, and utility is constant, an increase of price of one commodity will lead to an increased demand for the other commodity. All commodities must have at least one substitute, otherwise it will not be possible to keep the utility function invariant. For complementary commodities, an increase in price of one commodity will lead to a decreased demand for the other commodity. For example, coffee and tea are likely substitute commodities, whereas guns and bullets are likely complementary commodities.

  The concept of substitute and complementary commodities is applicable only when utility is held invariant by the price–budget income relationship of Equation 3.124 . When price and budget income are not so constrained, we say that a commodity is normal if the corresponding main diagonal component of ∂x /∂p is negative:

  (3.134)

  It is called a Giffen commodity if it is positive:

  (3.135)

  It is rare that a commodity is Giffen. A commodity is termed superior if

  (3.136)

  A commodity is called inferior if

  (3.137)

  For example, meat would likely be considered by many to be a superior commodity, and potatoes an inferior commodity.

  Elasticities play an important role in the theory of the household, as they did in the theory of the firm. We define the (cross) elasticity of the demand for commodity i with respect to the price of commodity j as

  (3.138)

  The elasticity of a given commodity with respect to its own price will usually be negative (again, the Giffen commodity is rare). Such an elasticity is generally called the price elasticity of demand and is defined by

  The (price) elasticity of demand will depend on the shape of the demand curve and also on the equilibrium position on the demand curve. Let us examine three relevant examples here. More are present in the set of problems at the end of the chapter.

  Example 3.11:

  For the particular case of a linear demand curve x i = a −bp i , we easily see that the price elasticity of demand is

  and we see that the price elasticity of demand varies from 0 to −∞ as the demand and price vary from a and 0 to 0 and a /b . For the case where b = 0, such that the demand is constant and independent of price, we have . This zero elasticity is called a completely inelastic demand. The other extreme is where the price is extremely insensitive to demand and a constant price results. For this case a = ∞ and b = ∞ in such a way that a /b = p i . Here the price elasticity of demand is −∞ and we say that the demand is completely elastic. To avoid obtaining negative elasticities for normal commodities, many authors define elasticities as the negative of the ratio of the percentage of change in quantity to the change in price. Figure 3.5

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  The Economics of the Popular Music Industry

  Modelling from Microeconomic Theory and Industrial Organization

  • C. Byun(Author)
  • 2016(Publication Date)
  • Palgrave Pivot

    (Publisher)

  The above discussion about indifference curves was based on two typical goods, X and Y for which the consumer has a standard preference structure and between which there is a degree of substitutability given by the MRS. The shape of the indifference curves is determined by the consumer’s preferences and by what type of goods they are. But there are some goods that have a particular relationship with one another. More specifically, there are two categories of goods, perfect substitutes and perfect complements, which we must now define. These definitions are important because these types of goods appear frequently in the music business and have a significant bearing on the direction the industry is taking.

  Goods are defined as perfect substitutes if they are perfectly interchangeable with one another, and the consumer is equally satisfied with consuming either one. Examples of perfect substitutes are different brands of goods that are identical (except for some minor superficial aspects) such as pencils, reams of copier paper, bottled water, and so forth. Another example is Coke and Pepsi, although they are more like close substitutes rather than perfect substitutes since are most likely some consumers who have strong preferences for one brand over the other. In any case, the utility a consumer receives from consuming one brand of bottled water is identical to that from another, thus the consumer is indifferent between bottle of water or the other (or from pencils, reams of paper, etc.). If two goods are perfect substitutes, then this means that one good can be substituted for the other at a constant rate, with no loss of utility to the consumer. This implies the indifference curves would be straight lines (with a negative slope). Recall that the marginal rate of substitution is the slope of the indifference curve, and it represents the rate of tradeoff of one good for the other, while keeping the consumer’s utility constant. If two goods are perfect substitutes, a consumer can substitute consumption of one pencil for another (or one bottle of water for another, etc.) and remain at exactly the same level of utility. This implies that the MRS is constant and slope of the indifference curve is constant, and in the case of bottled water, the slope is −1/1 (in other words one bottle of water is interchangeable for another). Figure 2.6

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