What it means
Tea and coffee, butter and margarine, and a taxi and a ride-hailing app are everyday examples. The products are not identical, but a buyer can swap one for the other without giving up the purpose of the purchase, such as a hot drink in the morning or a trip across town.
The closer the substitute, the stronger the effect. If a rival brand is almost the same and costs less, a small price rise can send many customers away, whereas a product with no close substitute can often raise its price with little loss of sales.
Economists measure this with cross-price elasticity of demand, which shows how much the quantity sold of one product changes when the price of another product changes. A positive figure means the two are substitutes, and a negative figure means they are complements, which are bought together, like printers and ink.
The degree of substitution also depends on time and habit. In the short run, customers may stay with a familiar product despite a price rise, but over months they find alternatives, so the full effect often appears later than managers expect.
Substitutes matter in strategy as well as in pricing. A company analysing its industry looks at the threat of substitutes, because a new technology or service from outside the industry can erode demand even if existing competitors behave sensibly.
Streaming services replacing physical discs is a familiar case. For finance teams, the practical use is in forecasting and risk.
When a supplier raises prices, a business can ask whether a substitute material exists and what it would cost to switch, and when a competitor cuts prices, it can estimate how many sales are at risk.
In practice
Real-world examples.
Example
A cafe raises the price of its filter coffee by 20%. Many regular customers switch to tea, so the owner decides to introduce a loyalty card to protect coffee sales. She reviews the weekly sales report to see whether the lost coffee revenue is replaced by tea.
Example
A furniture maker uses oak, and the price of oak jumps sharply. The purchasing manager tests a cheaper timber and finds that customers accept the change for most products.
Example
A regional airline faces a new high-speed rail link between two cities it serves. Rail is a close substitute on short routes, so the airline cuts the number of daily flights on that route and moves aircraft elsewhere. The finance team updates its forecasts for fuel, crew and airport fees on that route.
Formula
Calculation
Cross-price elasticity of demand = % change in quantity demanded of product A / % change in price of product B
Brand B coffee rises in price from $5.00 to $5.50, which is a 10% increase. Sales of Brand A coffee rise from 10,000 bags to 10,600 bags, a 6% increase. The cross-price elasticity is 6% / 10% = 0.6, and because it is positive the two brands are substitutes. If Brand A sells at $5.00 a bag, it gains 600 x $5.00 = $3,000 of extra monthly revenue from its rival's price rise. A figure close to zero would mean the products are unrelated, and a figure far above 1 would mean customers switch very readily.Case study
Seen in the real world.
Greenfield Dairy is an illustrative, fictional business that sells milk through supermarkets. When it raised its prices by 8% to cover higher feed costs, sales of its own milk fell by 12%, and sales of a plant-based alternative at the same stores rose by 15%.
The finance team calculated that the cross-price elasticity with the plant-based drink was positive and large enough that further price rises would hurt volume. They also noticed that the decline was strongest among younger customers.
In this illustrative story, Greenfield held its prices, cut costs in distribution and launched its own oat-based drink. The decision turned a threat from substitutes into a second product line, and revenue recovered within a year. The board now reviews substitute products at every annual strategy meeting.
Watch out
Common mistakes.
- Assuming a substitute must be identical, when it only needs to meet the same need at an acceptable price and quality.
- Ignoring substitutes from outside the industry, which are often the most dangerous.
- Confusing substitutes with complements, which move in the opposite direction when prices change.
Questions
People also ask.
What is the difference between a substitute and a competitor?
A competitor sells a similar product in the same market, while a substitute can come from a different industry and still meet the same need.
How do I know if two products are substitutes?
Check whether a price rise for one raises sales of the other, which shows up as positive cross-price elasticity.
Can a business reduce the threat of substitutes?
Yes, through brand loyalty, product differentiation, switching costs and keeping prices fair relative to alternatives, and by watching what customers actually switch to.
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