Definition of substitute goods – Substitute goods are two alternative goods that could be used for the same purpose.
- Substitutes present the consumer with alternative choices.
- If the price of one good increases, then demand for the substitute is likely to rise.
- Therefore, substitutes have a positive cross elasticity of demand.
Graph of two substitute goods
- In the diagram on the left, there is a fall in the price of Android Phones causing consumers to demand more. (movement along the demand curve).
- As a result, there is a fall in demand for the substitute (Apple iPhone) leading to less demand.
Cross elasticity of demand
Cross elasticity of demand measures the responsiveness of the demand for one good in relation to a change in the price of another.
For example, if the price of Android phones falls 10%, demand for the iPhone may fall 5%.
The XED of Android in relation to iPhone will be +0.5.
Close Substitute Goods
- If two goods are close substitutes, there will be a high cross elasticity of demand.
- Example, if the price of Sainsbury’s flour increases 10%, demand for Hovis flour may increase 20%. To consumers there is little difference between the two goods. Therefore, the cross elasticity of demand is +2.0
Weak Substitute Goods
- If goods are weak substitutes, there will be a low cross elasticity of demand.
- Example, if the price of The Daily Mail increases 10%, the demand for the Financial Times may only increase 1%. Therefore, the cross elasticity of demand is 0.1. These two newspapers are weak substitutes.
- If the price of margarine increases 10%, demand for butter may rise 2%.
Two goods are perfect substitutes if the utility consumers get from one good is the same as another. For example a dollar from one FOREX
- A dollar from one FOREX company is worth the same as getting a dollar from a different FOREX company.
- A4 paper from Office World gives same utility as A4 paper from WHSmiths.
Therefore, in theory, if one good was more expensive, there would be no demand as people would buy the cheaper alternative.